Occasionally some of my friends ask me why I am hedged and market neutral in my investing. My answer is always the same. I invest for the long term, and the macro-environment remains very dangerous right now. I am confident in my ability to pick a portfolio that can outperform the market, but I can’t predict what is going to happen in the global economy, and the evidence is that the key players are not dealing with the problems at hand. Moreover, trends in economics and society are severely threatening the West’s future prosperity. With this in mind I thought I would outline the reasons why and then suggest a sector likely to outperform.
The lessons of the last recession are still not properly being learned. In fact, I don’t think they ever will be because the causes of it are so deeply ingrained into the nature of capital markets that they will inevitably repeat themselves in the future.
However, some things have changed. For the sake of brevity I will mention three things.
First, take a look at the following chart. This is data sourced from the IMF that outlines government debt/GDP. The shaded areas represent recessions.
United States Government Debt data by YCharts
My point here is that whenever the US entered previous recessions it always had the leeway to raise government spending (and consequently debt) in order to counteract the cyclical slowdown in the private sector. So what happens if there is another recession in the near future? The US Government (actually the US taxpayer) does not appear to be in a strong position to deal with it. In addition, borrowing rates are likely to be much higher, and if history is a guide then the cyclicality of the next recession is likely to increase thanks to globalization synchronizing the global economy.
Employment
Second, I don’t like the structural nature of unemployment in the cycle. Don’t get me wrong, I’m a great believer in the idea that employment will pick up this year but we need to put this into context.
Here is a chart that does that. This represents the percentage of jobs regained from those lost in the previous recessions . All data is non-farm payroll from the BLS.
Note how weak the current recovery is with only 62.7% of the jobs lost now regained, and these numbers do not include assumptions for new entrants into the labor market. Furthermore, note how with each recession it takes progressively longer to regain jobs.
The US has structural unemployment issues, and this is placing a burden on public finances and also on the way of life that post-War America came to understand as normal.
Demographics
The third issue is demographics. I’m going to lean on Charles Murray’s Coming Apart and highlight the differentials in marriage and divorce rates between poorer and wealthier segments of America. Things appear to be okay at the top, but marriage rates have imploded at the bottom while single parenthood rates have exploded at the same time. I’m aware these subjects are contentious but allow me a few brief words.
The great Aristotelian religions (Judaism, Christianity and Islam) survived and became so, because at the heart of them lies the nuclear family and respect for private property. I argue that we have never before been in an economic environment where the nuclear family has faced such a sustained onslaught from social commentators, sociologists, the media, divorce courts, and good old fashioned social engineering ‘do-gooders’ fixated on the idea of restructuring gender relations. You don’t have to agree with me on the causes (I stress feminism causing social pressure against marriage), but it is indisputable that the nuclear family is breaking down in America, and this is unchartered territory for the economy.
I would also argue that when a working class man loses the incentive or opportunity to form a family, he then loses a large part of the incentive to work. Similarly when he loses the opportunity to work (see above) hypergamy ensures that his options in the sexual marketplace are limited. These two issues are symbiotic and create significant economic problems, and it’s time the mainstream media started talking about these issues rather than discussing Kim Kardashian’s new hair cut.
Throw in an aging demographic and you have an economy that is gradually morphing itself into one that will have significant problems should it be hit with another recession.
How to Outperform
Of course it doesn’t have to be all doom and gloom. The global and US economy could go through another 10 years without a recession, gradually reduce debt burdens and offer a better quality of living for all. However, in both polar scenarios there are some things in common. One of them is that health care costs need to be reduced, and companies that help to do this will have plenty of upside potential.
In this regard the generic drug manufacturers like Actavis Inc (NYSE:ACT), Mylan Inc. (NASDAQ:MYL) or Teva Pharmaceutical Industries Ltd (ADR) (NYSE:TEVA) are set yo benefit. Increasing generic penetration rates is a good way to reduce costs and I have no doubt governments will be pressured to do this in future. Another area of opportunity will be from medical device manufacturers that offer tangible cost reductions. I think Covidien plc (NYSE:COV)’s Minimally Invasive Surgery (MIS) solutions are a good example of this. MIS offers patients better outcomes and consequently reduces patient stays; it saves money.
Another area that could reduce health care costs is affordable human genome sequencing . The leading players here are Life Technologies Corp. (NASDAQ:LIFE) and Illumina, Inc. (NASDAQ:ILMN), and if they can make sequencing affordable then health care costs could come down as individuals will be able to identify and detect indications that can be treated earlier and therefore save costs.
In conclusion, there are plenty of dangers out there, and I will stay hedged for the foreseeable future, but there are still areas of the economy that will outperform irrespective of the long term outcome.
The article Three Reasons to Worry and One Theme That Can Outperform originally appeared on Fool.com and is written by Lee Samaha.
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