Stock Market Strategies for the Post-Financial-Crisis 'New World Order'

[Editor's Note: If the recent thousand-point drop in U.S. stocks tells us anything, it's that we're now living in post-financial-crisis “new world order" in which the old profit rules no longer apply. As scary as that sounds, Money Morning contributor Jon D. Markman tells investors that now is no time to sit on the sidelines.]

For many investors, the recent thousand-point plunge by the U.S. stock market was probably the proverbial last straw.

So let me be perfectly clear about the point that I want to make here: Sitting on the sidelines could be the investment mistake of a lifetime. The post-financial-crisis "new world order" that's emerged from the speculative excesses, recessionary realities and regulatory breakdowns of recent years has created a world of lucrative new profit opportunities - governed by a new set of profit rules.

Let me explain...

When Negative News Fosters Positive Prospects

Let's face it: The last few years haven't been easy ones for the investing faint-of-heart. We've had ringside seats for the building-and-bursting of a global credit bubble - a bubble, incidentally, that involved the one thing most of us thought would always be safe: Our homes.

With that credit bubble as the catalyst, we were then treated to the near-collapse of our modern financial system, a severe worldwide recession, unprecedented government stimuli, and a historic rebound in financial asset prices from panic lows. And that wasn't even the end. We finally capped all that off with the 995-point near-freefall experienced by the Dow Jones Industrial Average back on May 6.

Last week, I told you I would look more carefully into the matter. If anything, my analysis has only strengthened my oft-stated belief that tremendous profit opportunities still lay ahead. In short, it is still a good time to be an investor - and is definitely not the time to abandon ship in anticipation of a renewed bear market.

To get some corroborative analysis, I turned to Craig A. Drill, a veteran fund manager and one of the true wise men of Wall Street who rarely speaks to the media.

In response to my e-mail query, Drill, the president and founder of New York-based Craig Drill Capital, and Steven H. Reynolds, his chief financial officer, told me that the events of recent years appear to have formulated the proverbial "Goldilocks" economy - one in which the growth rate is neither too hot (inflationary), nor too cold (recessionary): Liquidity is plentiful, interest rates are low and stable, inflation is muted, consumer spending is no longer a drag, exports are reviving, and profits are soaring.

In fact, it even appears that corporate profitability will achieve record levels in 2010.

Drill did note that the U.S. economy faces some powerful headwinds, including - but not limited to:

  • The scarcity of business and consumer credit.
  • Excessive fiscal deficits.
  • Escalating sovereign debt risk.
  • A high level of unemployment.
  • Worrisome conditions in China.
  • And a global financial reform movement.

Viewed separately, those could each be viewed as a troubling trend. In the current post-financial-crisis new world order, however, those factors are combining to create a "just-right" reality that should enable the U.S. economy to maintain a truly self-sustaining expansion.

New Rules for a Post-Financial-Crisis World

Investors continue to hold historically high amounts of cash and fixed-income investments. Across the broad spectrum of institutional and individual investors, there are significant shortfalls in actuarial and retirement needs that have to be replenished. To satisfy these deficiencies, many may reluctantly move to a greater risk exposure following sizeable declines like the recent thousand-point drop.

In response to my request for his analysis of just what he thought was behind that late-day freefall, Drill replied: "Technology, fast trading and quant models outstripping human common sense. Bubbles bursting in the carry trade. Fear of things we don't understand hitting too much complacency. God teaching us to be humble."

True enough. And characteristically succinct.

More interesting than what caused the event is the new rules of investing that will result.

According to Drill, the problem with a moment like the one we face right now is that the traumatic shocks the global economic and financial systems have taken make it unlikely that investor psychology will return to its pre-crisis state: The failures and fixes have altered the landscape, meaning the "traditional" methods of analysis will likely need to be modified, he says.

The Post-Financial Crisis New World Order All Stars

By viewing economies through this post-financial-crisis prism, investors can define an investing new world order that is no longer segmented by geography (such as Asia, North America and Europe) or stages of economic progress (emerging and developed markets). Instead, countries will be categorized according to their financial soundness.

At the top of this investment-new-world-order "risk list" are the economies that entered the crisis with strong financial systems. Coming in second and last are those that came to the crisis over-leveraged and under-regulated.

There's a big difference between the top and bottom groups: While countries that were prudent in the regulation and supervision of their financial activities could not avoid the global meltdown and recession, Drill observes, their financial systems were able to withstand the stress. Traditional monetary and fiscal stimulus proved effective, enabling their financial institutions to transmit public policies to the private-business and household sectors.

As the result of a quick return to economic growth, several of these countries have already begun to withdraw their stimulus programs, Drill says. Interest rates are being raised in Australia, Canada, Norway, China, and India - several of which Money Morning has for some time been recommending to readers as being profitable - and relatively safe - alternatives to such beaten-up giants as the United States, Japan and Europe. All of these economies stand out as countries that successfully survived the financial storm.

These countries have the advantage of financial flexibility. That means they also have the ability to manage their economies more effectively, and should be able to generate above-average growth and gain a bigger share of world profits, Drill explains.

The post-financial-crisis "new-world-order" lesson to remember: From an investment point of view, companies that operate in - or sell products and services to - these countries should be market leaders. India, for instance, has outperformed the United States, Europe and China since January 2009.

Question of the Week

The New World Order Losers

In contrast to the prospective winners, profligate countries were nearly ruined. Government actions stabilized their systems through measures unprecedented in speed and size, Drill says, and the negative consequences of the financial crisis on their economies will be felt for years.

Drill and his investment team have identified three major problems for these countries:

  • Bad debts have soaked up huge amount of financial relief that would normally have flowed through to the general economy.
  • Consumers are limited in their ability to accelerate purchases of housing and autos, the traditional jump-starters in an economic recovery.
  • And the high rate of unemployment requires high levels of social-welfare payments that are also worsening budget deficits at the state and local-government levels.

In the countries with impaired financial systems, Drill believes fiscal stimulation has only provided stabilization, not a platform for higher growth. Since these countries account for 40% of the global economy, their sub-par growth rates will reduce demand for imports, inhibiting global trade. These countries, he thinks, have allowed investment-banking constructs to invade government, so that massive, complex, opaque schemes may only push problems out in time - without having really solved them.

The post-financial-crisis "new-world-order" lesson to remember: This analysis results in an outlook of moderate growth for the financially damaged U.S. economy. While that may sound bad on the surface, it ironically provides for a long sweet spot for market participants - in essence, the so-called "Goldilocks" outlook. That is an outlook that will encourage and enable new bubbles, which are great in the short term for investors, though they are obviously bad once they run their course and pop.

That brings us to the final question: What's the outlook for the stock market, and how do we position ourselves for that expectation.

The Stock Market in a Post-Financial-Crisis World

According to Drill and his investment team, as the U.S. economy shifts from a recovery led by fiscal stimulus and inventory restocking to a more moderate expansion, the stock market will become more selective. Many sectors, industries and companies will find it difficult to continue to make meaningful earnings progress on cost-cutting alone, Drill says. And that will result in two attractive areas of opportunity for investors:

  • Companies that can show strong-top-line growth in a sub-par economic expansion.
  • Undervalued small-cap and micro-cap companies that have been overlooked by Wall Street.

The post-financial-crisis "new-world-order" lesson to remember: As the new bull market unfolds, a new leadership group will emerge comprised of companies that can achieve strong revenue, free cash flow (FCF), and earnings growth via product innovation, market-share gains, and exports to - or operations in - countries with sound financial systems.

Investors will be drawn increasingly to this select group of growth companies -- much like the Nifty 50 of the 1960s - whose valuations should expand from today's conservative levels. Cognizant Technology Solutions Corp. (Nasdaq: CTSH), one of our Strategic Advantage advisory service holdings this year, is a good example, as are Apple Inc. (Nasdaq: AAPL) and F5 Networks Inc. (Nasdaq: FFIV).

The great credit collapse and recession of 2008-2009 was very harmful to large companies. But it was even more ruinous to mid-cap, small-cap and micro-cap stocks that were sold without any regard to their fundamental strengths. Indeed, and many bottomed at prices near their cash balances.

In many instances - since these firms don't have a lot of access to promotion via Wall Street research - this substantial undervaluation can persist. So you often have little-known public companies that are growing quickly on their own merits and thus are the subject of a lot of merger-and-acquisition interest - both from larger peers in their industries, as well as from private equity firms.

One prime example: With its recent offer to buy Dollar Thrifty Automotive Group Inc. (NYSE: DTG) for $1.27 billion, Hertz Global Holdings Inc. (NYSE: HTZ) bid $41 a share for a stock that could have been had for $1 a year ago.

This is an argument in favor of owning select mid-caps and micro-caps, as we have this year in our Strategic Advantage "ETF" and "StrataGem" portfolios. We'll have more to say on these topics here in Money Morning in the months and weeks to come. But if you really want to read about these issues - innovation, market-share gains and financial sobriety, each of which will do a lot to shape our investments over the next decade - you might want to take a look at Strategic Advantage, as well.

[Editor's Note: As this analysis of the post-financial-crisis "new world order" so clearly demonstrates, Money Morning Contributing Writer Jon D. Markman has a unique view of both the world economy and the global financial markets. With uncertainty the watchword and volatility the norm in today's markets, low-risk/high-profit investments will be tougher than ever to find.

It will take a seasoned guide to uncover those opportunities.

Markman is that guide.

In the face of what's been the toughest market for investors since the Great Depression, it's time to sweep away the uncertainty and eradicate the worry. That's why investors subscribe to Markman's Strategic Advantage newsletter every week: He can see opportunity when other investors are blinded by worry.

Subscribe to Strategic Advantage and hire Markman to be your guide. For more information, please click here.]

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