What a miserable quarter. The S&P 500 has now dropped 10% so far this year, which looks great relative to the Asian and European declines of 18%. Small and middle sized companies fared no better than their global peers, dropping 17% year to date.
Political Brinkmanship Continues
There were plenty of issues to worry about—very few of which had anything to do with the near-term outlook for corporate earnings. For the last three months, politicians were the villains. First, the debt ceiling debate highlighted the inability of U.S. politicians to compromise. Then it was the Europeans’ turn to show investors how dysfunctional they could be. With the fate of the European Union in the balance, the leadership vacuum in Europe undermined any confidence that investors might have had regarding the possibility of a near-term solution.
For the last few weeks, the markets have moved up 3% when it appears that European leaders are making progress, then down 3% when the consensus starts to fracture. As the saying goes, the first step on the road to recovery is recognizing that you have a problem. Finally, Europeans’ increasingly recognize the severity of their sovereign debt crisis and the importance of solving it. Unfortunately, a consensus has yet to emerge regarding the type of solutions that will most effectively address their crisis.
Europe Must Bail-Out Their Banks
The position of the U.S. as articulated by Treasury Secretary Geithner is that Europe must recapitalize their banks, using a program similar to the Troubled Asset Recovery Program (TARP). The experience in the U.S. during the 2008 credit crisis suggests that bailing out the banks is essential to maintaining the flow of credit.
The ability of a bank to lend is a function of its asset base. European banks’ largest asset is government debt. The asset base declines as government debt depreciates. Lending ability decreases as banks write-down the value of their asset base. Consumers’ purchasing power falls as the supply of credit dwindles.
If the European Union wants to maintain access to credit, it must stabilize the asset write-downs. Currently, the European Central Bank is buying Italian and Spanish debt, having previously purchased Greek debt. The ECB purchases government debt from European banks that are trying to reduce their exposure to the depreciating debt.
Europe created the European Financial Stability Facility or EFSF. This facility has a mandate to buy up to $590 billion of distressed government debt. Outstanding Greek debt is about $490 billion. This leaves only $160 billion. The biggest concern is that Europe will be unable to guarantee the sovereign debt of Italy or re-capitalize banks that lose big in the event of an Italian debt default. Italy is the third largest borrower in the world behind the United States and Japan. France is the largest Italian creditor. Investors fear that a contagion effect will impact banks around the world making a tough economic environment even more challenging.
European Leadership is Lacking
When you aggregate the resources of Europe it appears to be in a stronger fiscal position than either the U.S or Japan. The problem results from a lack of centralized European leadership. Each of the seventeen member nations has veto power over any policy. As of Friday, fourteen of the seventeen Eurozone countries had passed legislation ratifying the Greek bailout that the finance ministers agreed to in July. The hope is that a coherent policy large enough to restore confidence will be in place by the time the G20 leaders meet in Cannes in early November. This all but assures that October will be as volatile as the last couple of months have been.
Tough Markets Force Policy-Makers into the Correct Policy
My core assumption is that pain in the markets forces policymakers to find a confidence restoring solution. Politicians may only do the right thing after trying everything else, but the market won’t let them give up. Based on our debt ceiling experience it also seems that the politicians will put off the hard decisions until the very last minute, or until a crisis forces them to act. But the history of liberal democracies is that eventually humpty-dumpty gets put back together again. Sometimes the process of restoration takes five to ten years, other times a full recovery is in place in less than a year.
This makes timing the market next to impossible. You have to know when to sell, know what to buy when you sell, then you have to know when to buy back in. Today, safety assets like CDs pay less than inflation while risk assets like stocks are extremely cheap. This is only the second time in fifty years that the S&P 500 yields more than the ten-year treasury.
Growing an economy is challenging enough in normal times. All of the anxiety over the politicians’ inability to lead us out of this difficult period is hurting consumer and business confidence. When expectations are for a tougher future, businesses and consumers become more cautious, which further restrains the economy.
Valuations are Attractive, Earnings are still Robust
The strongest argument against a recession developing is that the recovery hasn’t advanced very far. The most cyclical elements of the economy–inventories, housing, and auto sales are near their lowest levels post-WWII. There doesn’t seem to be much room for them to turn down.
Valuations in the market are already priced below recessionary levels. If recession does indeed occur, the market probably drops another ten-percent at the most. If a recession is avoided, and Europe recapitalizes banks and restores confidence, the market probably appreciates at least 20%.
Since the debt ceiling and the European debt crises flared up we have worked to move assets away from the companies that are most sensitive to global growth. We are replacing our most aggressive companies with high dividend paying stocks. We have also lowered our exposure to European and emerging market companies. This has served to decrease the volatility of the portfolio by about 20%.
The Federal Reserve continues to make low-risk assets very unappealing. Short-term Treasury bills are yielding next to nothing, while long-term bonds are yielding about 2%. This has the effect of forcing investors to assume more risk. People are shifting conservative CD portfolios into investment grade corporate bonds. They’re shifting investment grade corporate bond assets into blue chip dividend paying stocks like Proctor and Gamble and Coca-Cola. We are repositioning our stock portfolios to make sure that the lowest risk stocks are the largest component of our strategic equity allocation.
Markets Bottom when it Looks Like Things Can’t Get Any Worse
This crisis will eventually abate. Investors who have properly considered their long-term investment objectives shouldn’t dramatically change their long-term allocation. As always, we recommend that investors allocate assets that are needed for income within the next five years into low risk investment strategies. For assets that you expect to leave invested for the next five years, low-yielding low risk assets don’t seem to hold any appeal.
We’re in an unusually volatile period. While the 24-hour news cycle can make it appear as though the world is coming to an end, it’s not. The business cycle is a never-ending process of recession and expansion, but over time, the value of the U.S. and global economy grows.
We will eventually go into recession again. Whether it will start in 2012 or 2015 is impossible to know. The most important fact to consider today is that eventually confidence will improve. It may get worse before it gets better, but we are going through a particularly challenging period. Pessimism has rarely been greater. But, once we have some clarity on how Europe is going to resolve its debt crisis and how the U.S. is going to resolve its long-term deficits, confidence will improve. Markets will focus on earnings and corporate balance sheets that are as healthy as they’ve been at any time in the past fifty years, and stocks could rally as they did in 2009.
