Stock markets around the globe have plunged in August. The numbers are staggering. Both the S&P 500 Index (large companies) and the Russell 2000 Index (small companies) have declined sharply. The stock market is extremely unstable and the next move is largely unpredictable.
While the markets seem to have many concerns, the two primary problems appear to be worries over sovereign debt and budget deficits in both the US and Europe, and fears that the global economy will slip into another recession.
These concerns have been present for most of the last several years. In fact, the market had a similar correction last summer over the same issues. Stock markets recovered strongly in the second half of 2010 as the economy showed signs of strength.
The recent debate over raising the US debt ceiling and the downgrading of US debt by Standard and Poor’s have brought to the forefront problems that have existed for some time but have generally been ignored by politicians. While the budget and debt problems are significant, the US is a wealthy country and the problems can be solved. Although the attention to these matters has caused the market to react negatively, the fact that politicians are finally addressing these problems should be a long-term positive for the US economy.
Economic weakness in the US in the first half of 2011 can be at least partially attributable to trade disruptions due to the Japanese earthquake and higher oil prices. Both of these headwinds should abate in the second half of 2011. While economic growth is likely to remain sluggish, it should continue to be positive and a recession does not appear to be likely.
Corporate earnings have remained strong and are expected to increase throughout 2011 and into 2012. Corporate earnings and cash balances are currently at or near record levels.
While the recent sharp declines in stock prices are reminiscent of the crash in 2008, there are a number of differences. The most important difference is that the credit markets are operating normally; in 2008 the credit markets became dysfunctional. In addition, major financial institutions are in much better shape currently, having been forced to adhere to higher capital standards.
The most disturbing aspect of the recent market correction is the speed in which it occurred. Some pundits have blamed hedge funds, high-frequency traders, or panic selling. In the past five years the market has demonstrated a high level of volatility, which gives stocks a higher risk profile compared to other asset classes.
While it is impossible to say if the current correction is over, it does appear to me that stocks have become very cheap compared to their expected earnings, cash flows and underlying assets. Although the current stream of news is negative, stocks appeared to be positioned for strong returns if the economy continues to gradually expand and fears of a recession subside. In this regard, the current correction is viewed as an opportunity to cautiously add equities to our portfolios.