MARY BERSOT CFA — The US stock market is held hostage to the European headlines which are contributing to wild swings in prices and investor uncertainty. Europe will move in the right direction at some point and the strength in our economy will overshadow these concerns. In the meantime fear of a severe recession in Europe or a falloff in emerging market growth could aggravate the problem. These concerns, which are valid, will cause our market to be volatile well into 2012 and investors will remain on sidelines. If this isn’t enough, our deficit reduction debate in the midst of election rhetoric will cause more confusion and volatility in our market. Our focus on economic headlines is unprecedented.
The US continues to recover from a severe recession, brought about by excessive borrowing and a bubble in the real estate market. It will take years, and probably a decade, to recover and restore our country’s balance sheet and economic growth. Morgan Stanley looked at economic growth after financially induced recessions. They found GDP was reduced by about 1.5% from what would otherwise be normal (about 3%) for a decade after the recession. In 10 of the 15 recessions they examined employment never got back to where it was before the recession. We need to accept the fact that we will not have robust growth or full employment for some time. It is a mistake, however, to assume that it will never happen.
GDP growth in the US is on the mend but signs of stress have emerged. Consumer spending is strong as we move toward the holiday season. Exports helped reduce our trade deficit and new housing starts snapped back in September from August’s slump due to poor weather. The most recent unemployment claims report shows that very slow progress is being made in reducing the number of people filing for unemployment benefits the first time. It took years for our problems in housing and jobs to develop. Employers moved jobs overseas long before the recession and the bubble in housing took some time to build as more and more Americans took advantage of lax lending standards and low rates. The experience in Japan shows us that cycles can take as long as 20 years to build toward the peak, collapse and then recover. We can expect this to be the case for both our housing market and job market because of the severity of the recession. This fragile recovery needs global growth to sustain itself.
Social unrest in the US is not something to be dismissed lightly. There is a wide gap between the affluent, high income earners and the lower middle classes. This issue defines the differences between the political parties, which are center stage as we approach the 2012 elections. Tea party members couldn’t be further removed from the Occupy Wall Street supporters. Both groups might agree we have problems, but each solution couldn’t be more different. Occupy Wall Street supporters, who tend to be Democrats, want the government to do something to help the vast number of Americans who are struggling and tea partiers are likely to be Republican and opposed to government intervention. This issue will become more prominent and cause more concern as we approach the 2012 elections.
The crisis in Europe is alarming and all eyes are focused on any hint of a resolution or further deterioration in fiscal strength. Reduction of the high level of sovereign debt in European countries will reduce economic growth at a minimum and, if defaults occur in larger economies such as Italy and Spain, there will be failures in the financial system. It is likely Greece will default after leadership changes and attempts at spending reforms. The Greek debt level is just too high and leaves prospects for default alive. Policy makers in Europe need to support Italy and Spain to avert a major, global crisis. Headlines from Europe are directing our markets in the short-run and it is clear a solution, or solutions, need to be found to stabilize the weaker countries and avert a major financial crisis.
The US capital markets, at current levels, will be able to sustain this bad news as long as US company involvement is minimal, which is expected. The biggest impact will be to global US banks and asset managers that have invested in shaky sovereign debt in the search for growth. The projected impact from this European crisis is not threatening to the overall US economy at this point. Our exports will decline if a recession in Europe develops which could impact US growth 0.5% at most. Without the risks and problems in Europe our economy would be attractive. A resolution to the immediate problems in Europe would eliminate a major headwind and our stock market would respond very favorably.
Asia is much more dependent on the world economies than they were in the last financial crisis. Over 40% of their exports go to the US and Europe. If either or both regions fall into recession for any length of time it is likely global growth will slow. This inter dependence among countries is one reason policy makers around the globe need to band together to solve this European crisis.
We wrote in October that “we don’t want to dismiss the seriousness of these issues but we do feel the stock market reflects them and valuations are attractive”. The key is to gauge the level of the market in relation to the headlines and risks. Caution is warranted when there is blatant disregard for the risk which is not the case today. In fact, it is more likely that investors are overly focused on these economic concerns and ignoring strong company fundamentals. The US stock market is not expensive and stocks are already discounted because of these concerns.
The US Bond Market
The US bond market is trading at high prices and low interest rates not seen in decades. The concerns in Europe have been a catalyst to seek quality over return and funds have gravitated to our Treasury market – a perceived safe haven. This happened at the same time the Federal Reserve committed to low interest rates until 2013 and stock investors pulled out of the market due to fear. All stars were aligned to drive high quality corporate bonds and Treasury issues to prices that will, looking back, seem way too high. It is only a matter of time before confidence in the economy is restored and investors realize the dividend yield on the S&P 500 is higher than the return on the 10 year Treasury. This relationship – where more income is available from stocks than bonds- isn’t sustainable. If and when – more likely when-interest rates rise, investors could see losses as great as 20% in their long term bond holdings. This will be a surprise to individuals who expected bonds to be the safe haven in retirement.
Higher interest rates are inevitable. Bond investors will anticipate a rise in rates before the Federal Reserve’s 2013 timeline for raising them. This is even more assured if our economy continues on a solid recovery path and the European crisis is averted. Interest rates could decline a bit before they rise, but over time long term interest rates will be higher.
This is also true for tax exempt bonds, which trade as a percentage of US Treasury obligations. These yields have dropped to low levels and high quality bonds are trading at very high prices. Recommendations may surface from the debt debate in Washington to reduce or limit the exemption of state and municipal bonds as a way to raise revenue. If enacted, this legislation would be a disaster for local governments who depend on borrowing at lower rates, but anything is possible as politics and social drama weigh heavily on high income investors.
Diversification is important and there is a place in most portfolios for bonds. They have historically provided an assured rate of return and repay principal on maturity. It is still true you will be paid the par value on maturity but the rate of return today is not high and the bond prices, on paper, could drop significantly if interest rates rise. If a bond allocation is warranted it is best to hold shorter term bonds and cash and put the money in long bonds when rates rise from these very low levels.
The Stock Market
How do you address this crisis in confidence and invest funds for the long term? Does it make sense to invest in anything other than a sturdy mattress to hide funds under? Yes. One reason might be surprising – demographics. Older individuals typically reduce higher risk assets as they retire and use principal funds to support their lifestyles. Traditional financial planning models call for an increased amount of bonds as age increases based on the notion that safety should come first.
This is not true today. Baby boomers, as identified by those born from 1946-1964 are beginning to retire and many are not prepared and hope to work past age 65. Investors in this age group drove stock prices higher as they saved for retirement and were a big factor in the rise in home values as they bought and traded their homes. The argument is that they will do for the bond market when they retire what they did for the stock and real estate markets.
What’s wrong with this argument? This would make sense if this age group lives only another ten years. However, the average life expectancy in the US is over 80. The prudent thing to do is assume you will live to be 90 as modern medicine extends our lifespan and we are willing to pay for whatever is needed. The time horizon for a retired individual has doubled! The major concern today is that assets will not last long enough to support us. This will cause financial planners and advisors to re think their strategies and include more stocks, including international stocks, in the mix. We are seeing this now, especially with income higher from stocks than bonds in many cases.
The US stock market is also redefining itself. It is not only retired individuals who are gravitating toward quality, global companies that pay dividends and have a history of increasing dividends. Investors with lower risk profiles or concerns about the state of the market prefer income today over potential returns in the future. The best source of income is from large, multinational companies flush with cash. If inflation runs at 3% there is no way to stay ahead of the game for 20 years with a high allocation to bonds at today’s rates. Large, dividend paying stocks have performed the best this year and could continue to do well, in spite of the problems in Europe.
Asset allocation is important and difficult in this low interest rate environment. The threat of a market decline is real if the problems in Europe are not resolved and debt is not reduced around the globe. However, it is not clear that many quality companies won’t do well, even if growth is slow. This has been true since our own recession as emerging middle classes around the globe are attracted to our products and brands. The other asset classes, such as cash and bonds, are less attractive at today’s low interest rates and it is by no means assured that stocks will decline from today’s level. A balanced approach is best over the long term.
And, if the market declines because of economic problems and lack of confidence then it will come back. It always does. From the chart below we see that since 1929 the years after major declines (the dips below zero) are positive. The wild swings in prices may continue for some time and investors will move quickly from fear to greed and back. These swings can provide opportunity to add to stocks at attractive prices.
It is virtually impossible to time the market and get the sales and then reinvestment exactly right. The best strategy is to trim quality companies when the market is high and then add back to the same issues at lower prices. To raise cash and abandon stocks is rarely successful. Most investors are afraid to buy at the bottom, when fear is the greatest and it feels like things can’t get worse. That’s exactly when buying produces the best results. Emotions take over and it is hard to invest when everyone else is afraid.
International investors are also attracted to our market. If stocks in the US decline relative to other markets foreign investors will gravitate where the expected return is the greatest. This global investment focus and the expanding life expectancy of the largest segment of our population could prove positive for stocks.
US companies are stronger than ever. Cash balances are very high and the amount of announced dividend hikes and stock buy backs are at historic levels. Corporate America is lean, substituting technology for labor whenever possible. We also have to remember that companies today allocate their resources and focus on the economies where the growth is greatest. The headlines in Europe, social unrest and high unemployment in the US are troubling. It is easy to forget that two thirds of the world is doing fine. It is possible, and likely, earnings from many US companies, which are now over 50% from foreign revenues, will remain strong as we work through our economic problems. In the end, it is earnings that drive stock prices.
Investors need to be selective. Twenty two percent of our exports are to Europe, so a major recession in the region would reduce earnings for some companies. Not all stocks will do well in this environment and problems are punished. It is frustrating to buy a stock one day to find it lower the next. Focusing on fundamentals is very important and valuation is very important. There are stocks that are priced to fully reflect the worst case scenario and this may be an excellent time to buy them, not sell. It isn’t what a stock does today or tomorrow, it is the growth over time, from dividends and capital appreciation that builds wealth. We have seen time and time again that buying when fear is the greatest produces outstanding returns.
Don’t confuse economic headlines with the stock market. We are facing an election in the US, a debate on how to handle our huge debt level and political polarization not seen in decades. While this is happening US companies are building plants in Brazil and China and generating sales where economies are growing. Balance sheets are the strongest they have been. We don’t buy our economy, we buy companies and for the most part they are doing just fine.
Mary M. Bersot CFA