Author: Eric Linser, Green Valley Wealth Advisors
Covestor model: Eagle Portfolio
Disclosures: None
In a follow up to my recent post (https://investing.interactiveadvisors.com/2011/08/heat-wave-of-summer-politics-green-valley-wealth-advisors), things have quickly deteriorated in the U.S. and international stock markets. The US equity market has dropped sharply from its high of late April, as have international indexes.
Clearly the stock markets remain immersed in panic mode, so we will not be making a new bull market high any time soon. The only question mark in my mind is how long the current volatility will extend before the bull market in stocks resumes. That is not clear, as the stock market is oversold and set to bounce, but after the bounce it could make another lower low. For that low, my best guess is for a range of 10,750-11,000 on the Dow. Stocks historically tend to make major lows in September and October, thus that is the timeframe I see for the bottoming process to be set. After that, we could see the stage set for a nice fourth quarter rally through mid-January.
From rapid descents, I look for buyers to step in and snap up bargain stocks that they’ve been eyeing to own. If this fails to happen, then I’ll be further concerned that sellers have not relented in getting out of stocks.
The Bottom Line
The bull market is not over (yeah, I know that’s hard to swallow). The current correction has major indices such as the S&P 500 and the Dow well off from their highs in late April. Investors with money to put into the market have an opportunity to accumulate ‘target’ stocks and will likely get that opportunity over the next few months, after which the future prospects for stocks for the balance of the year will become much clearer.
Start of a new bear market?
While I can’t rule that out, it is certainly a summer slump that has turned into a downright rout. The relative mild summer correction has clearly morphed into a market panic as of mid-August. August can be a hot and volatile month and tempers can flare, and so far it’s been just that.
In early August, S&P put another nail into the coffin of the US economy by downgrading its credit. The Eurozone continues to trend towards default of PIIGS countries (without huge injections of capital that the European Central Bank must provide) and we’re seeing sharply higher interest rates demanded on the sovereign debt of these PIIGS. So all of the bad news is true, but ultimately all this does is to accelerate the ‘stagflation’ trend that wallops consumers through a worsening job outlook with higher prices (such as energy, health care and food costs, to name a few). These are trying times, and that negativity flows throughout the markets and the economy. Confidence has severely waned.
Something had to give. The tumbling of the market would have happened sooner or later given a deteriorating economic picture. So the S&P proclamation just sped up the process. But now we are at an interesting juncture. Stocks are down hard; it’s a hefty discount when there is no proof yet of a recession and corporate America just had a great earnings season. It could be said that risk and reward are now evenly matched, and the next step for the market should be based upon the fundamental outlook.
It appears that that if the economy is not headed into a recession, stocks are a bargain and should head higher from here. Unfortunately, the flip side is true as well. If we do slip into a recession, stocks could possibly lose another 20-30% from these levels.
How to preserve and grow capital in such a climate?
That’s what everyone really wants to know. Investing involves risk, even if one picks relatively low risk, large cap dividend paying stocks. There still is significant risk involved, which is why I believe investments should be accumulated into ‘target’ stocks with a view to long-term holdings that span many years, if not decades. That, in my opinion, is how you actually beat real inflation, not from jumping in and out of holdings on the latest scare or market panic that takes all stocks lower regardless of each stock’s differing fundamentals.
Keeping things in perspective
At its very core, the stock market – like any market – is a discounting mechanism and a leading indicator. It may seem quite basic, but (without getting too dramatic) all of our hopes, dreams and fears are translated into what prices are today. As we were reminded from the 2008 experience, when many high-quality equities that had nothing to do with the financial crisis fell to prices that were below book value, markets have a tendency to overshoot to the extremes. Often this overshoot is behavioral and reactive in nature, with little to do with individual company fundamentals. Do you think underlying business values in the U.S. are worth several percent more or less now (in mid-August) than they were in the short time since late July?
When a rating agency downgrade occurs (as S&P did to the US government), the typical response is for interest rates on affected bonds to rise—in keeping with a larger credit spread and an implied higher risk on those assets. Ironically, following the S&P’s downgrade, the opposite occurred: the stock market sold off in favor of the traditional low-risk investment, the US Treasury. Despite S&P’s decision to lower their status from “AAA” to “AA+,” Treasuries represent the largest volume and highest liquidity of these types of investments in the world. Therefore, the market served to essentially reinforce their low-risk status, as it has many times throughout history and during the past few years when we’ve seen the “risk-off” trade occur.
It is also important to keep in mind what a rating agency is actually evaluating—it’s the “ability” and “willingness” to pay off interest and principal on outstanding debt. Based on the corporation or country involved, either or both could be the issue at hand. Very few economists/strategists (or us) had any doubts about the ability part. However, it was the political willingness to resolve our differences in a timely manner that most concerned S&P. We find this less concerting than if “ability” were the actual problem, at least in the near-term.
I live in California. As of August 2011, we have the worst state credit rating in the nation at “A-.” Our state’s finances are a mess, like the federal government’s, but we’re making strides to get them in order. The state of California has the propensity to continue to pay its bills when due. Heck, we even take 100 days sometimes to get a ‘balanced’ budget deal done. Like California, the U.S. will continue to pay its debts; I don’t question that. At least California’s credit rating is “stable” and was bound for an upgrade before this whole federal debt ceiling mess.
There is a lot of underlying uncertainty in the world, from a variety of directions—it’s this type of uncertainty that markets tend to shy away from, and discount. The important thing is that none of this news is in fact “new.” We’ve been wrestling with these issues for several months, if not longer.
The Eurozone debt crisis is a continuation of problems several years in the making, and will likely require additional interventions and liquidity injections similar to the US financial system in 2008. These actions can serve a financial role, but perhaps more importantly serve as a confidence backstop of “someone” providing a market for these bonds. Nevertheless, there will be haircuts and plenty of pain to go around (it’s called austerity and we as Americans don’t handle that well at all) — this is something most strategists discounted long ago, before the politicians started to think about it in July.
The economic recovery in the US and developing world has slowed. In part this can be attributed to the Japanese disaster and higher energy prices, but, in general, recoveries after severe financial recessions can be choppier than average, and can take longer to kick in. This is also true with unemployment. We have seen some slight improvement here, but the pace of growth has not been rapid enough to buoy us out of a chronic state of pessimism. GDP numbers for the first half of 2011 have been revised lower, but second half estimates remain higher than current levels, and a bit closer to a normal recovery. Should these be realized, or, at the very least, we achieve better GDP than where we stand from the first half, it should provide an optimistic backdrop for risk assets.
What could go wrong?
As always, any number of things. However, it’s important to look at this in context. On the negative side, we have obstinately high unemployment. Hiring has apparently been hampered by a lack of clarity in the future environment—again, it’s about confidence—and that can become a self-fulfilling prophecy to a certain extent. Housing is weak, and may even weaken further, but it would be difficult for us to build fewer new homes than we’re building right now to keep up with long-term demographic trends.
What could go right?
Several things are already going right. Corporate earnings results remain strong and growth rates are well into the double-digits, and revisions are strongly positive. Firms are earning increasing amounts of revenue from overseas operations (especially emerging markets), which has been a big boost. So corporations are in good shape, which fundamentally tends to serve as a backbone for stock values.
What does this mean for our portfolio?
Diversification has become increasingly important not just from a risk-reduction standpoint over time, but also as a means to capture alternate sources of growth. This concept served as a catalyst for our heightened allocations to international investments, and we feel that a global view now offers more opportunity than ever—in both equity and fixed income assets. We beat this drum often, but we believe valuation is key to investment results.
Our gut-level behavioral responses during times like this are likely a day late and a dollar short. It isn’t possible to completely avoid hiccups from time to time, just as it isn’t possible to guess the exact exit and re-entry points to avoid these hiccups. Volatile markets are fickle and often run counter to conventional wisdom—fear is the only constant. Buying (or at least not selling) when others are fearful is a centuries-old nugget of wisdom that has often been proven fruitful.
Wishing you continued health, wealth and prosperity,
Eric Linser, CFA
