Market Perspective for 9/15/11
I’ve been trying to put my arms around the financial events of the past two weeks. Clearly the employment picture in the United States is deteriorating. It is more of a “slow leak” than falling off a cliff, since there wasn’t a big hiring boom during the recovery from mid-2009 through early 2011. Nevertheless it is not a good sign. Neither is the sharp decline in both investor confidence and consumer confidence. We are going through a painful de-leveraging process and that historically brings subpar economic growth. There is not much that can be done to help the situation. What we may need, more than anything else, is political leaders that understand the situation and can explain it to the people in a way that makes them feel better yet does not give them false hope. Perhaps we need a Winston Churchill-type “It’s going to be long and hard but we are all in this together and we’re going to make it through” speech. Unfortunately, the stock market believes there is nobody with that kind of character and gravitas in Washington right now.
The dilemma for us as investors is to determine whether the current sell-off has created the conditions for an investable bounce. Since unemployment and consumer confidence tend to be lagging indicators, the stock market can rally while they are negative. After all, bull markets don’t go straight up and certainly bear markets don’t go straight down. So have the twin sell-offs at the beginning of both August and September set us up for a stock market rally? I believe the answer is yes. The question is whether it will persist long enough and carry far enough to even bother trying to reposition portfolios to take advantage.
Stocks are currently oversold at these levels, small caps especially. European stocks have gotten hit even worse. Since the dollar has depreciated 5% versus the Euro year to date, European stocks are only down a little over 12% in dollar terms. To a European they are off close to 17%. Their story is somewhat the same. Investors are reacting negatively to the political circus that involves “have” countries like Germany and “have-not” countries such Greece. Complicating things for them are the various bureaucrats and banks that have conflicting agendas. The thing is, in markets when it seems like things can’t get any worse they usually do get better. When nobody is left to sell, the only direction stocks can go is up.
I believe investors forget some times that a stock market is made up of individual companies. At any given time, stock price movements may exaggerate the actual change in the earning power of the underlying companies. Even with the deceleration in the economy, most companies are doing well. In general, they have seen lower financing costs, their payrolls are lean, and profit margins are among the highest levels ever recorded. The only negatives have been higher commodity costs and (for companies that cater to consumers) lackluster demand. I believe stocks could support higher valuations if it were believed that a credible plan for growing our economy would meet with bipartisan support. Technical indicators (the early September lows were in almost all cases higher than the early August lows) support the idea of at least a short term rally, and investor sentiment is low enough that the “weak hands” are probably already out.
In deciding whether or not to buy into the next rally, we have to recognize that stocks tend to fall a lot faster than they rise. The four month rally from New Year’s Day to the end of April was fully negated in less than six weeks, for example. I could see the S&P 500 testing 1270 (the June lows, 9% above current levels) before year-end. That said, there is enough risk from the precarious state of Europe to render that a risk probably not worth taking for most investors. A European default could (that is COULD and not WILL) create the kind of global financial uncertainty that we had in 2008. It would be foolish not to recognize that this is a possibility, and it would create a lot of turmoil at least in the short run.
Here is the risk as I see it. I believe that European bankers and German and Finnish citizens do not understand that there are no historical examples of a successful large-scale austerity program. If my family is running a large deficit, for example, we can spend less and produce (work) more in order to put things right – ONLY if it is assumed that everybody else continues to produce and consume at roughly the same rate. If they also try to produce more and consume less, none of us is going to dig our way out. In fact, we will all be worse off than we started (aggregate economic activity will have declined). Putting a hundred million people in Southern Europe on an austerity program will not work unless the Northern Europeans who are running a surplus are willing to run down that surplus buying from those who need to earn more than they spend. Europe’s situation is not fixable unless they can coordinate a policy between nations that addresses this fundamental fact.
It is an ill wind, however, that doesn’t blow some good. The economic slowdown in the U.S. and Europe will slow down inflationary pressures in emerging markets, and bring down fuel costs (all other things being equal) in developed markets. The Pacific Rim and South America stand to gain if lower inflation allows China and India to stop raising interest rates and even eventually ease interest rates in the coming months. I would be looking to taking advantage of the roughly 15% decline in emerging markets to being scaling back in. You can probably wait until the beginning of October. Use the inevitable bad days in Europe as entry points.
The other interesting point I would like to touch in in this post is the report Litman Gregory did that calls into question the whole notion that small cap stocks outperform large cap stocks over time. The report was very interesting reading. The truth may come down to calculation methods. The SIGNIFICANCE of the report is this: Reports like this tend to come out at a time when the psychology is already changing and it provides the intellectual justification for investors and money managers to do what they felt like they should do anyway, which in this case was start moving toward large caps. Jeremy Siegel’s books Stocks for the Long Run (1994) is another example of a book that was very successful because it came just at the right time to underpin the great asset allocation tsunami (bonds to stocks) in the latter half of the 1990s. I predict that 2011 will mark the clear beginning of the long awaited shift from small to large and that this trend will hold for many years.
Past performance is no assurance of future results.
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