Investing in a declining economy

(This article is based on the research undertaken by the Research Team of Regina Capital Development Corp., a member of the Philippine Stock Exchange.)

The World Bank in its June 2023 report, Global Economic Prospects, projected global growth (GDP) to decelerate from 3.1% in 2022 to 2.1% in 2023. For the Philippines, the World Bank projected GDP growth to decline from 7.6% in 2022 to 6% in 2023, 5.9% in 2024, and 5.9% in 2025.

Our fellow columnist, Romeo L. Bernardo in his column of June 19, “Growing Pains,” projected a lower GDP growth of 5.5% in 2023 but a recovery to 5.8% in 2024.

On a quarterly basis, Nomura Securities in its June 9, 2023 “Asia Economic Monthly Report” projected 2nd Quarter 2023 growth to decline from the 1st Quarter 2023 growth of 6.4% to 5.6%. Moreover, Nomura projects 3rd Quarter growth to decline further to 4.8%.

When the economy declines, we can also expect the stock market to decline.

Fortunately, market declines, like tropical storms, can be detected early and their probable path plotted, giving us time to prepare for the coming storm.

Moreover, in coping with the coming storm we can look for guidance from the foremost investor in the world, Warren Buffett. According to Buffett, a contrarian, a recession is one of the best times to look for investment opportunities. In 2008, he wrote “Bad news is an investor’s best friend. It lets you buy a slice of America’s future at a marked-down price.”

Buffet’s comments reflect the view of some investors that stocks go through a cycle as shown in the first chart (See Figure 1).

This chart shows that the best time to buy is when the cycle is on the downturn. Or, as Buffett states more colorfully, “When people are greedy, I am fearful and when people are fearful, I am greedy.”

Drawing from this and other sayings of Buffet, we propose the following plan.

LIQUIFY YOUR PORTFOLIO
As stated, we can roughly predict when the stock market will decline. Using the investment cycle, we have charted the movement of the Philippine stock market from 2009 to the present (See Figure 2).

Note that with the exception of 2020 when the COVID-19 epidemic started and the market dropped precipitously and then rebounded sharply in 2021, the Philippine stock market has followed the investment cycle and so is expected to continue dropping until 2024.

Knowing this, the prudent strategy would be to conserve your cash and dispose of some of your stock investments to increase your cash position.

But which stocks to sell? For that we need a short course in Investment Analysis 101.

Stocks are valued for what they presently earn and what they are expected to earn. If a stock is expected to earn more in the future, then the price of the stock, a growth stock, will be higher than a stock which has the same present earnings but is not expected to earn more in the future.

Let us take the case of two American companies; General Motors Co. and Tesla, Inc. In 2022, General Motors had a profit of $9.9 billion while Tesla had a profit of $12.6 billion or 27% higher. And yet the market value of Tesla of $816.3 billion ($257.50 market price per share as of June 29, 2023 times 3.17 billion outstanding shares) is 15.4 times higher than the market value of General Motors at $53.1 billion ($38.20 market price per share as of June 29, 2023 times 1.39 billion outstanding shares).

Investment analysts use a ratio called Price/Earnings Ratio (Market Price per share divided by Earnings per share) to measure how highly the market values the share of the company. In the case of Tesla, the P/E ratio is 65.02 times while in the case of General Motors the P/E ratio is only 5.4 times. Thus, when times are good, Tesla is considered a growth stock compared to General Motors. Conversely when times are bad, the prospects of Tesla are direr than General Motors and so we can expect Tesla shares will fall deeper. In sum then, if we liquefy our stocks in anticipation of a declining market, we should sell Tesla and not General Motors shares.

BALANCING YOUR PORTFOLIO
When the market does decline —i.e., Tesla shares declining after we have sold our Tesla shares — we get the opportunity to correct past investment mistakes. Let us say you invested in General Motors but now wish you had invested in Tesla Motors. Now that Tesla shares have fallen further than General Motors shares, we can switch from General Motors — i.e., sell your General Motors shares to Tesla Motors, i.e., buy Tesla Motors shares. This is based on the assumption that Tesla Motors shares will have declined more than the General Motor shares. (See Figure 3.)

This transaction involves you taking a loss of 20% in the price of your General Motors shares in exchange for a prospective gain of 36% on the price of your newly acquired Tesla Motors shares.

REVERSING PORTFOLIO STRATEGY
At a certain point, the economy will recover and so will the stock market. Unfortunately, the stock market is a leading indicator for the economy. This means stock prices will recover before the economy recovers. We should therefore reverse our strategy of conserving cash to expending cash well before the economy recovers.

Again, we are fortunate given the advice of BlackRock, a leading investment advisory firm, which stated, “History suggests investors may be rewarded when stepping out of cash and moving into investment grade fixed income and equity exposures when the fed stops raising rates.”

And when will our Bangko Sentral ng Pilipinas stop raising rates? We quote Finance Secretary Benjamin Diokno: “Our expectation is that inflation may hit below 2% by the first quarter next year because of base effects. That will be the time for considering the cuts because globally, inflation remains persistent. We’re just trying to be more conservative.”

In sum, we should start reversing our portfolio at the start of the fourth quarter this year.

Dr. Victor S. Limlingan is a retired professor of AIM and a fellow of the Foundation for Economic Freedom. He is presently chairman of Cristina Research Foundation, a public policy adviser and Regina Capital Development Corp., a member of the Philippine Stock Exchange.