The market has been fast all week, meaning that just as soon as you write finish writing something the market changes and what you wrote seems dated. Suffice it to say that the volatility has been surprising in light of the fact that the issues we are dealing with – the U.S. debt situation and the European Sovereign (read: country specific) Debt Crisis – have been with us for quite some time. What is new, and what has been moving the market in the past few days, is the shift in psychology from viewing the current weak spell in the economy as a pause in an ongoing recovery to a slide back into recession. Why is this important? Because today traders are a far larger percentage of day to day volume than are investors. If a trader believes we are in an economic “soft patch”, he is looking to take advantage of the downturn by buying on weakness. If, however, he loses the belief that the economy will be better six months from now, he starts looking to sell stocks into strength.
The economic slowdown in the developed markets of Europe, Japan, and the U.S. is the greatest worry now for investors. With growth in the first quarter of 2011 revised down to a paltry 0.4% and unemployment rising from 8.8% back up to 9.2% over the past four months (back to 9.1% as of this morning), it is clear that the U.S. economy has all but stalled out. Back in 2009 I referred to the Federal Reserve’s accommodative monetary policy as “lighter fluid” because it was designed to give the economy a large, short term boost. The idea was that by 2011 the economy would be strong enough on its own not to need any more of the Fed’s help. Today the lighter fluid has burned off and much of the economy never caught fire. To be fair, given the over-building in the residential real estate sector and the virtual collapse of the home finance industry (due to its own negligence), some sectors wouldn’t have caught fire no matter what kind of policy we tried. It is going to be a long, slow slog to economic recovery.
If there is a bright side for investors it is that profit margins for mid- and large-size businesses are at record levels. Corporate America saw what happened in 2008 and decided that they would not be held hostage by the capital markets again. They may not be able to control their stock price, but they can make sure they have enough cash on hand not to have to borrow at the ridiculous rates of late 2008. This is one of the reasons why I and the great majority of investment professionals are very confident we won’t see a repeat of 2008. The other is that investors are not positioned as aggressively as they were at the top of the market in 2007. Many investors who lost big in 2008 never really came back to stocks. If people aren’t losing money nearly as fast, their sense of panic will be far less. That said, the freshness of the 2008 experience will cause some to think “Here we go again”. This is why volatility will remain high for some time to come. At least this time we have a properly functioning bond market so we can balance some of the economic risk of stocks. Bonds are doing quite well right now for the most part.
It is also important for investors to realize that to some extent the world’s currency, stock, bond, and commodities markets function as a means by which investors seek to influence policy makers. Don’t like the recent debt deal? Sell stocks and/or the U.S. dollar; buy gold or Swiss francs. Of course this works proactively as well. Want the Federal Reserve to launch another round of quantitative easing? Sell stocks and buy long dated U.S. Treasury bonds, effecting telling the Fed that you believe that the economy is headed for deflation.
The bottom line is that despite a relatively decent economic report this morning investors are concerned about the U.S. economy falling back into recession. While this shouldn’t have nearly as much impact on Corporate America today as it did three years ago, many investors don’t want to take any chances. The rest of the world is also struggling more or less so there just aren’t enough reasons to feel optimistic about stocks in the short term. As always, this bout of short term weakness sets up greater return potential in the intermediate and long term time frames. Tactically, we are shifting portfolios to larger, more financially strong companies and somewhat away from smaller, more economically sensitive ones. We are also increasing the maturity of our bond portfolios to take advantage of the fact that we don’t see inflation being a problem anytime soon.
Past performance is no assurance of future results.
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