Bear market, not market crash

5 Questions with funds manager Werner Engelhardt

1. Are the international stock exchanges currently facing a correction? Or is the probability of a stock market crash increasing?

"Crash" is a big word, but in my opinion a bear market is the most likely of several scenarios. It is no secret that the valuations have been striving for their all-time highs for a long time, especially in the US, however it has been long dismissed with a shrug. Even more dangerous are the margins currently being higher than at any other time in history. This combination is dangerous in the medium to long run. The powder keg is there. So far, that was not an acute problem as long as the technical situation was in order.

Unfortunately this is where there’s been trouble for the past months, so now the fuse is attached. Markets are based on crowd psychology to a degree that mustn’t be underestimated. Before the high in January, the market had just gotten through many months of unhealthy low volatility. The amount of futures of the typical institutional trend followers has reached increasingly extreme maxima in many markets. The stock quotas lately settled on the level of the very late `90s. Consumer confidence as high as never before and savings rates near the all-time lows complete the picture. Last but not least, the hype about cryptocurrencies shows that we are much closer to the end than at the beginning of a bull market.

2. Are you currently making tactical changes in your portfolio? If so, which are those?

Against the mentioned background, we started setting up our portfolio more defensively as of mid-January. As one of the biggest investors in the two Lacuna Health Funds, my interests are closely linked to those of our investors. I see it as part of my task to bring the capital entrusted to me through all market phases as well as possible. Our goal is not to track the index - for example, the active quota at Lacuna Asia Pacific Health is close to the 100% mark. We also have the necessary freedoms for the cash quota. And in exceptional situations, such as the current one, we also safeguard the portfolio directly.

3. What do you think about the dangers of a possible trade war between China and the US?

No one can seriously tell right now where exactly the spark to ignite the powder keg will come from. A trade war is an option - but ultimately it would just be the trigger since the problem lies deeper, as described before. In the case of a trade war, we see only very manageable risks in the Lacuna portfolios, as none of our US and Chinese investments have any significant trading relationships with the other market. Particularly the Chinese companies are very focused on their home market, which makes them very robust for such exact scenarios.

4. How do you rate the interest rate scenarios and what do rising interest rates mean for your portfolio?

Last year, the bond market in the US probably ended a bull market lasting more than 35-years. The increase to about 3% worries many investors, and justifiably so. In the medium term further rising interest rates are a realistic scenario. As a result, bonds are increasingly becoming a serious competitor to investors' capital, posing a threat to the stock market. But we are looking forward to it relatively calmly. On the one hand, health is one of the most defensive sectors and tends to do very well in times of falling markets. On the other hand, much of our funds are invested in Asia, a market that does not directly depend on the interest rate situation in the West.

5. In your opinion, which markets and sectors are currently undervalued?

Naturally, there aren’t many after almost 9 years since the latest great depression. In the US, the choice is nearly impossible. A number of European markets appear a bit better - but those are often too closely connected to the development of the US market. As far as price performance is concerned, the main drivers are the emerging markets. And those who prefer to avoid Russia, Brazil, Turkey and South Africa for understandable reasons are quickly finding themselves in a number of Asian markets. A much more positive demographic development compared to North America, and above all Europe, and an enormous economic potential to catch-up paint many of the Asian markets in a completely different light. Low government and consumer debt is the rule and not the exception; the valuations are usually much cheaper.

Asian markets

I can only explain the assessment of Asian markets being riskier than European and especially North American ones with a look in the rearview mirror. This is one of the big misunderstandings and probably the biggest mistake in the vast majority of portfolios. In a world of problematic equity and real estate markets in developed nations, rising bond rates, and zero interest rates on the money market, anyone with a rational mind can’t ignore overvaluation of Asian stocks. Of course, there are industries in this region that now have a high "temperature" as well. In the long term, that may not be a problem, but in the short and medium term, I suggest including defensive sectors threatened with only small negative impacts due to a potential slowdown in the economy.

Health industry

Companies in the sectors utilities, telecommunications, consumer staples and healthcare are the obvious choice here. However, especially the first two sectors are very interest sensitive and typically also highly indebted. Consumer Staples are among the highest rated companies. The Asian healthcare market, on the other hand, is ideal: More than half of the portfolio of the Lacuna Asia Pacific Health consists of titles which have previously fallen from around 30% to over 50%. The mood in these cases is rather reserved to negative, the times of exuberant imagination is usually one to two years in the past. In addition, almost or completely debt-free balance sheets are the rule. I don’t envy colleagues who only invest in North America and Europe.

Pharmaceutical wholesale

An industry in which we have been investing heavily is the pharmaceutical wholesaler. The shares of the three dominant US wholesalers AmerisourceBergen, Cardinal Health and McKesson were recently valued at around 11, which, in my view, is still far too cheap given the oligopoly market position and the extremely stable business model. Fears of a market entry by Amazon formed the background. I have always considered these exaggerated as the three companies are already running extremely efficiently and I saw no competitive advantage for Amazon in the market. A few days ago, Amazon then announced to end its efforts to penetrate the market.

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