Despite the S&P 500's massive rally this year, fund manager Steve Romick warns that soaring levels of sovereign and corporate debt to new highs could inflict major turmoil on the stock market. Romick has good cause to be worried. As head of the $17 billion FPA Crescent fund (FPACX), he is 70% invested in stocks. To protect against a stock meltdown, Romick is buying equities with a five to seven-year investment horizon, which he argues will outperform, including American International Group (AIG), Jefferies Financial Group (JEF), Charter Communications (CHTR) and Comcast Corp. (CMCSA), per a lengthy interview he gave to Barron’s.

 4 Stocks To Navigate The Storm

(YTD Stock Performance)

·     American International Group: 11.8%

·     Jefferies Financial Group: 17.9%

·     Charter Communications Inc.: 19.7%

·     Comcast Corp.: 9.4%

Source: Investopedia

Romick’s FPA Crescent fund holds equities, cash and bonds. Over the past three, five, 10 and 15 years, the moderate asset-allocation fund has beaten the average for its peer group, including funds that hold 50% to 70% of assets in stocks and the rest in fixed income and cash. FPA Crescent was buying up equities during the 2018 downdraft, yet still maintains a quarter of its assets in cash.

Upheaval in Corporate and Sovereign Debt

Romick argues that while many have focused on the high debt facing consumers and banks, both are actually in better standing than before, per Barron's. Meanwhile, corporate debt and sovereign debt keep him up at night. “Sovereign debt levels are as high as they’ve ever been relative to gross domestic product around the globe,” said Romick, citing the highly leveraged U.S. Treasury, as well as state and local governments across the U.S. “This rapid debt expansion can’t continue forever. At some point, there will be a price to pay in the form of slower economic growth or recession. Buyers of sovereign debt could demand a higher yield. Corporate defaults could result from higher borrowing costs. The weak economy could cause lower cash flow,” he said.

U.S. Corporate Debt Surpasses $9 Trillion

Romick indicates that U.S. corporate debt is at its most elevated level in history, at over $9 trillion, with the highest leverage ratios outside of a recession and “some of the weakest covenants we’ve ever seen.”

While the risks of more high-yield, leveraged-loans are better understood, Romick said that there is a widespread lack of understanding with respect to investment-grade bonds. The market for high-yield bonds and levered loans grew from $1.3 trillion in 2008 to $2.4 trillion currently, nearly doubling. Meanwhile, the investment-grade market jumped from $2.5 trillion to $6.4 trillion over the same period. As a result of lower rates, “zombie firms” are surviving longer than they normally would.

AIG

Romick bought AIG right after the last recession. The investor is upbeat regarding AIG’s new CEO Brian Duperreault and COO Peter Zaffino, both insurance industry veterans. He expects new management to move the company forward in its initiative to improve property and casualty underwriting. AIG shares have staged a comeback in 2019 and Romick views its valuation as attractive.

Jefferies

Romick also likes broker dealer and merchant bank Jefferies, which he calls a quality business with good owner-operators. He notes that while Jefferies repurchased 13% of its shares last year, its stock fell 35%. As a result, the shares traded at less than 80% of its book value and “about a 30% to 35% discount to our conservative low-$20s assessment of net asset value,” he said.

Looking Ahead

Romick's sober view of the markets reflects the new caution investors have in the wake of the fourth-quarter plunge. The big question remains whether Romick or any investor can successfully handpick stocks that will prosper amid the next market downdraft - and thus avoid getting pulled down by it.