MARY BERSOT CFA — In November, 2011 we wrote:
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 valid concerns 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.
It is interesting that these words are still true today. Not much has changed. Investors remain on the sidelines and funds continue to flee US stock funds in favor of low yielding bonds. This will reverse and when it does it will call to question the notion that bonds are the less risky investment.
The US recovery is subpar by any measure. It has been three years since the great recession and it will probably take a decade to fully recover and restore our country’s health and growth rate. Morgan Stanley looked at economic growth after financially induced recessions. They found annual 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 the level it was before the recession began. Recent headlines confirm that this recovery is no exception. Initial claims for unemployment are still in excess of 350,000 and the housing market is still mired in foreclosures and homeowners with home values below cost. Oil prices have dropped in recent weeks providing some relief and perhaps encouragement for consumer spending.
Japan’s experience shows us that cycles can take as long as 20 years to build toward the peak, collapse and then recover. Our fragile recovery needs global growth to sustain itself and problems in Europe raise concerns this is not the case. The European Central Bank is caught between a rock and a hard place; austerity measures to reduce debt will slow spending and reduce economic growth while temporary steps to remedy the problem would kick the can down the road but not solve the problem. Over time
European countries will either move closer together with more coordinated governments or weaker countries, such as Greece, will exit the European Union. Regardless of the path, it will be a long and bumpy road to economic prosperity. In the meantime, headlines will cause confusion with continued uncertainly and volatility in the global capital markets.
The US stock and bond markets should be able to withstand the news flow as long as US company involvement is minimal which we expect. The biggest impact will be to global US banks and asset managers that have invested in shaky foreign bonds in the search for high returns. The projected impact from this European crisis is not threatening to the overall US economy at this point because corporate America is healthy, flush with cash, seeking opportunities where there is growth and conservatively managing their businesses.
The Fiscal Cliff
A cliff brings to mind a sudden and significant drop and a fall over the edge is a calamity rarely survived. The “Fiscal Cliff” is the worrisome and sudden end of tax cuts implemented under President Bush. At the end of this year, if Congress does not act, income taxes, estate tax rates and capital gains taxes will reset to much higher levels and emergency unemployment benefits will expire. In addition, there will be forced cuts in defense and healthcare spending and payroll taxes will rise. All of these together would significantly reduce GDP growth to almost zero and likely cause an increase in unemployment (fig 1). If allowed to expire, we could find our economy very close to recession once again.
Both political parties have strong and vastly differing views as to taxes and spending but in the end both should and probably will realize a compromise is necessary, given how slow our economic recovery is. The fear is the parties’ political positions are too far apart to find common ground. A compromise may not happen until after the election and it is probable Congress will extend the tax and unemployment benefits for 3 or 4 months into 2013 to deal with the situation. The uncertainty will cause worrisome headlines but we believe the end result will be a compromise because everyone knows that doing nothing will almost guarantee another recession.
We hear and read a lot about our country’s high debt levels. It might be surprising then to know that we, as a country, have lowered our total debt more than in any time since 2005. The private sector (individuals, corporations and families) continue to reduce the amount owed. Government spending is the problem and this will be an ongoing topic and concern through the election. The outcome of the election will be critical in deciding how this plays out with the size and role of government vastly different depending on who is elected. Government debt and spending are out of control and steps have to be taken to remedy the problem.
Today’s concerns are well telegraphed. It will be a surprise or a situation we haven’t anticipated that moves our markets one direction or the other. In the meantime we will trade in narrow ranges, with wide swings daily depending on the most recent headlines.
The Bond Market
Bonds are the beneficiary of today’s global concerns. As Fig. 2 below shows, US bonds are trading at high prices and low interest rates not seen since 1950.
Global funds have fled to our Treasury market – a perceived safe haven. Frightening headlines in Europe have been a catalyst to seek safety over return leaving investors earning less on their investments than today’s inflation rate. This has continued at the same time the Federal Reserve is committed to keeping interest rates low and fearful stock investors are exiting the market and flocking to bond funds. The end result is unprecedented demand for high quality corporate bonds and Treasury issues trading at prices today that will, looking back, be too high. It is only a matter of time before confidence in the economy is restored and investors will be faced with losses on their bond holdings. 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.
Higher interest rates are inevitable down the road. However, as long as GDP growth is slow (below 3%) and inflation is under control as it is today, the Federal Reserve will remain committed to a low interest rate policy. Investing in this low rate environment is a challenge – interest rates are low everywhere there is quality and stability. These are turbulent times and investors are more focused on preserving capital than they are growing their fortunes. This has been an ideal environment for our US Treasury market and bonds in general, both tax free and corporate.
If the worrisome headlines from Europe subside or if our economy begins to show signs of real strength bond prices will move higher. Bonds purchased today will be trading at much lower prices. Our economy is on the mend and Europe is slowly working through their problems. Growth in the emerging market countries is slowing, but still is higher than growth in the US or Europe. Time is the long term investor’s friend. In time these problems, and headlines, will subside.
It won’t take much to send interest rates higher and the absence of negative news may be enough of a positive catalyst to compel those hiding in bonds to seek higher returns elsewhere, including stocks. We may look back on bond prices as we have home prices and wonder why we didn’t see a bubble forming. A good strategy today would be to hold some cash, keep bond maturities relatively short and focus on quality. When interest rates rise to where they were before the recession then long maturity bonds issued today could be trading at double digit losses.
Headlines from Europe and at home are concerning but the question is; are these risks already reflected in stock prices? Is this why the S&P 500 P/E ratio is well below levels suggesting overvaluation? The P/E ratio at the peak of the market in 2000 was 30X and today it is 13.4X. We wrote on several occasions in the past year that “we don’t want to dismiss the seriousness of these (economic) issues but we do feel the stock market reflects them and valuations are attractive.” This is still the case. 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 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. Fear is driving investors to accept returns well below the cost of living. A sign the market is oversold is often this excessive fear.
It would take a substantial shock or significant earnings declines from here to drive stock prices lower and keep them there. Corporate America is healthy and managements have learned to move to economies that are growing. The strong US dollar and the slowdown in Europe may reduce reported earnings some, but at the current level of the market this risk is priced in especially for investors with a long time horizon. Never before has it been more important to focus on the long-term and take advantage of negative sentiment and volatility to buy quality companies.
Higher taxes on dividends and capital gains would reduce returns. We don’t expect the tax rate on either to match the top income tax rate and we believe there will be a compromise. Both political parties know that to significantly increase taxes when the economy is not at full strength is inviting another recession. It is also the growth in dividends, not the absolute amount paid, that attracts long term investors. Growing dividends will depend on earnings growth and the strength of corporate balance sheets, both of which are strong.
Stock markets are rumor mills. Uncertainty may persist for some months aggravated by the media and pundits who worry about stock performance over days not years. We are already seeing the absence of negative news as positive. It is usually a contrarian buy signal when investors use market advances to reduce risk as they have been recently. Just when investor sentiment is the most negative a piece of good news comes along and the market moves higher. The news media plays to today’s concerns, making matters worse. The risks and concerns are real. However, you have to believe there are no solutions and we are headed for another severe and prolonged market decline to stay away from stocks at these levels. Our economic recovery is sluggish and below par but we are not in a recession. Our companies are raising dividends, buying back stock and growing earnings. It is the increase in shareholder value that ultimately determines stock prices.
All stocks and companies are not the same. We have pockets of corporate America with very real problems. For example, many banks still have a high percentage of home loans underwater and are struggling to grow revenues in this low interest rate environment. Stock selection across all sectors is the key to success. We have seen a migration to defensive companies with high dividend yields. As confidence recovers cyclical stocks, with earnings tied to economic growth, will take the lead. Technology stocks are at historically low P/E multiples and energy, industrial and materials stocks have been weak due to fears of a global slowdown. All are poised to recover and perform well with any sign of renewed global growth.
It isn’t easy to pick stocks in this market. Hedge funds short stocks, sellers overreact to negative news and if you pay attention to headlines and ignore fundamentals you can miss long term opportunities. Market timing doesn’t work, but volatile markets provide opportunity to buy quality companies at attractive prices. This has been a crazy year for stock investors. We saw stocks rise 12% in the first quarter, only to lose again in the second quarter. Very few stocks drove the market higher – it was not widespread gains that fueled the rally. This means many companies and industries are still attractively priced if you take the long term view.
A good investment program today would be to look beyond the headlines and keep in mind that fears and emotions are the enemy of successful investing. Yields of 3% are available from quality stocks, far exceeding the 1.50% on a ten year Treasury note. This unusual relationship may last for awhile, but not forever. The risk today is not in the stock market – it is in high bond prices that will correct when interest rates move to more normal levels. It isn’t a matter of if – but when – this happens.
Mary M. Bersot CFA