Global economic momentum is modest at best, equities and bonds are overvalued, and while allocating your funds entirely to gold, cash and shorts is enticing, it isn’t possible for the majority of money managers. What are investors to do then? The ranking of creditors and equity in the capital structure suggest that high grade corporate bonds—and sovereigns—is the optimal allocation. When the goings get tough, the equity is wiped out, but as creditor you are at least assured a recovery on your investment; even if it may be a slim one. This time could be different, however.
As an alternative I propose equities with zero leverage. There aren’t many around, and those that do remain unlevered are looked upon with suspicion by the market. After all, if the CFO hasn’t jumped on the bandwagon and issued debt to finance dividends and buybacks, she must be an idiot. But if you believe—as I do—that corporate bonds is the new bubble, being overweight equities with no leverage isn’t a bad idea. These securities won’t be immune to a crisis, but they offer two key advantages.
Firstly, they likely will decline less than their overlevered brethren and the risk of a bankruptcy is smaller. If a repeat of 2008 really beckons, capital preservation may turn out to be the key metric of survival, no matter the drawdown. Secondly, buying equities with zero, or very low, leverage is also a free option. If we are wrong, and the debt finance buyback and dividend party goes on, a portfolio of equities with zero leverage eventually will join the party too. In all likelihood, that means excess returns for your stocks.
Once leverage has increased you can sell and go looking for another batch of firms with no leverage, primed to lever their balance sheet to hand out money to shareholders. We concede that this latter rationale partly is a contradiction. But we would rather buy firms with a clean balance sheet, than the alternative of buying equities that have already maxed out their potential for debt financed shareholder gifts.
Confusing charts; no directional clarity
Meanwhile, looking at the macro, strategy and technical charts has left me confused, a bit like Macro Man I suppose.
Macroeconomic leading indicators have stabilised based on the most recent data. The year-over-year rate in the U.S. and EZ headline indices have climbed marginally, and risen strongly in China. In Japan, however, the message from the headline index is grim. Global money supply growth has turned up further, helped by the U.S. and China. It is particularly encouraging to see that M1 growth has accelerated slightly in the U.S.
On on the contrary, my short-term charts of the market are sending a very unclear message. In the U.S. put-call ratios point to further upside despite the recent rally, while the adv-decline ratio continues to roll over. My equity valuation scores point to a slow grind higher in coming months, before a sell-off takes over towards the end of the summer. In sovereign bonds, I remain bearish.