[dropcap]T[/dropcap]hird Quarter Market Recap. The third quarter of 2011 felt eerily like the third quarter of 2008, not a good feeling for most investors. The US lost its AAA rating from Standard and Poor’s, and markets fretted about a likely sovereign debt default by Greece. The quarter highlighted the benefits of diversification at the asset class level. The S&P 500 was down about 15%. Foreign stock markets were generally down more, in dollar terms. Treasuries and the dollar rose. Gold sold off late in the quarter but still finished up about 10%.
Market Outlook. The market, like all of us, is uncertain about the outcome of the European sovereign debt crisis and economic growth rates in the US. The possibility of contagion in Europe leading to a breakup of the Euro is already partially discounted in stock prices. If it happens, things will get worse, but much of the potential negative is already reflected. If it does not, prices should rise. Meanwhile, there are several bullish factors we believe are being largely ignored. On balance, we find the bullish case compelling and believe fear has reached a level beyond economic reality. Please see page four for an overview of the major bullish and bearish factors for stocks.
US Economy. Many act as if it is certain the US will dip back into recession. However, the economy has been resilient and has recently shown more signs of improvement than decline. Recession remains a very real possibility in the next few quarters, but we are optimistic the economy will maintain modest growth before picking up next year.
Cracks in the Great Wall. Incremental negatives in China have begun to surface. China will not be able to maintain growth close to 10% for much longer, if at all. How it slows is important. Investors were temporarily spooked after finding out the US Department of Justice was investigating accounting irregularities at Chinese companies. Also, the HSBC Purchasing Managers Index showed a reading below 50 for two consecutive months. It would be premature to call for a hard landing in China, but it is worth watching closely.
US Presidential Election. We believe the election is the Republicans’ to lose, although Obama still stands a good chance if the stock market recovers and/or unemployment improves. The current list of Republican candidates is mediocre at best. Still, it’s early and the list of frontrunners can change quickly. With the possible exception of Rick Perry, who has more radical views on economic issues, the stock market should be satisfied with either party winning. On a positive note, the fourth year of any President’s term has historically been a good one for stocks.
1. Third Quarter Recap:
The third quarter of 2011 felt eerily like the third quarter of 2008. This was not a good feeling for most investors.
In 2008, poor risk controls around exposure to subprime mortgages led several major financial institutions to the brink of (or into) bankruptcy. Quite simply, they were creating toxic securities built from mortgages, keeping many of the securities on their own books, and booking the transaction as a profit in order to pay out huge compensation to employees. The result was a crisis in confidence among lenders and a freeze in global liquidity. Ultimately, the government was forced to rescue much of the financial industry, essentially nationalizing it in the process. This time around, reckless spending and poor budget management (as well as outright lies about national finances) have left certain European governments at risk of being unable to borrow money at sustainable rates. Once again, there is risk of a liquidity freeze as lenders wait for clarity.
The reality of Greece being unable to meet debt obligations was obvious as early as last year (if not well before), but finally reached a point where it could not be ignored this summer. Greece is a small economy, with a GDP just over $300 billion – representing under 2% of the Eurozone.
The absolute level of debt from Greece (just over $400 billion, and less than Lehman Brothers had at its time of death) is not a threat to the global economy, but there are three legitimate fears:
- Several banks have exposure to the Greek debt and could be put at financial risk themselves as a result. This could, in theory, cause other banks to freeze up until the dust settles, as was the case in 2008 (when bank problems were much more severe tied to the subprime mortgage mess).
- As private investors take losses on Greek debt, others may decide they are unwilling to risk a similar fate by lending to other vulnerable (and bigger) European economies such as Italy and Spain.
- If the Europeans are unable to find a solution and Greece has a messy default, they may be forced to withdraw from the Euro. This would cause all sorts of financial uncertainty as banks globally figure out who is to be paid back in Euros and who/how much to pay back in drachmas.
As of quarter end, the Greek drama is still being played out. In our opinion, it is likely to turn out as something of a tragedy for the Greek population, but like Argentina in 2002, not a memorable story for the rest of the world. Italy and Spain are, despite their problems, in much better shape than Greece and seem to be moving in the right direction. The threat of a breakup of the Euro is probably exaggerated as all of the major European governments seem to understand the extreme negative ramifications which could result and are determined to avoid it.
Communications from France and Germany after the quarter suggested that Europe will begin to use its bailout money for necessary bank rescues and stop pouring it down the drain by simply lending it to Greece and prolonging the issue. This means private investors (banks and otherwise) will be forced to take significant losses on Greek debt, as they should. More importantly, it means a sustainable resolution can take shape.
Back in the US, early in the quarter, government gridlock led the nation to the brink of default (or at least the appearance of it). As a result, Standard and Poor’s stripped away its sacred AAA rating. Investors did not care – US Treasuries rallied anyway. Ultimately, massive deficits in the US increase the risk of inflation sometime down the road. Whether inflation would surface in a few years, several years, or never is nearly impossible to predict. For now, as long as we maintain the power to print our own currency, default is extremely unlikely. We remain the safest bet available, and the extreme negative correlation between the US Dollar and global stock markets proves it.
In late September the Fed attempted to stimulate the sluggish economy and soft job market by forcing down long term interest rates. The tactic, known as “Operation Twist”, involves selling about $400 billion of shorter maturity debt and buying an equal amount of longer maturity debt. Bond yields did fall on the announcement, but so did stock prices. In our view, the move was a mistake. Interest rates are already low. The problem is not rates, but rather a lack of willingness from banks to lend. They will be even less likely to do so with a flatter yield curve.
Meanwhile, US economic numbers continue to come in mixed. Q2 GDP growth was revised up to 1.3%, which isn’t good, but is not a disaster either. Practically ignored, US corporations are doing very well with reported earnings in S&P 500 companies up 19% during the second quarter, according to Capital IQ. All ten economic sectors had positive earnings growth.
The quarter highlighted the benefits of diversification at the asset class level.
The S&P 500 was down about 15%. Foreign stock markets were generally down more, in dollar terms. Treasuries and the Dollar rose. Gold sold off late in the quarter but still finished up about 10%.
2. Market Outlook
What is the market trying to tell us?
Will the current market drop turn out to be more like 1998 (a sharp 20% decline driven by foreign debt concerns but followed quickly by new market highs) or 2008, which led to a severe recession and a 50% reduction in stock prices before a bottom was found in spring of 2009?
It is often said the stock market is prescient. This isn’t entirely true. Usually, the market doesn’t know what will happen. But it is a great handicapper. History is full of examples of stocks partially discounting a potential future outcome, only to leave the final verdict for history.
For example, US stocks dropped from 1937 through 1941 (other than a counter-trend rally in 1938), as the Nazi threat intensified. However, as it became clear that Hitler’s strategic blunders had cost him the war, stocks rallied sharply from 1942 to 1945. Had the outcome been different, which it very well could have been, stocks would have continued to drop significantly. The market didn’t know the final outcome, so it began to discount the probability of a bad event.
The market, like all of us, is uncertain about the outcome of the European sovereign debt crisis and the likelihood of suffering a double dip recession in the US. As clarity improves, the market will react. The possibility of contagion in Europe leading to a breakup of the Euro is partially discounted in stock prices. If it happens, things will get worse, but much of the potential negative is already discounted. If it does not, prices should rise.
The Bullish Case:
- Stocks are very cheap globally. The S&P 500 is trading at just over 10 times expected 2012 earnings, and the Stoxx Europe 600 Index at just 9 times expected earnings.
- Interest rates are extremely low. Historically, valuations of stocks are inversely correlated with interest rates, implying stocks should move to higher prices. The earnings yield on stocks is around 10%, compared to just 2% in ten year Treasuries. This is unprecedented, and is massively bullish if you believe earnings will continue to grow over time.
- Almost no one is bullish, but fear is rampant – this is usually a good sign.
- The Fed is acting in an extremely accommodative manner, promising to keep interest rates low through 2013 and essentially printing hundreds of billions of dollars to buy bonds and inject money into the system. Ultimately, this should be positive for asset prices.
- Corporate earnings are still growing, and corporate balance sheets are strong.
- The fourth year of a President’s term has historically been good for stocks.
- The housing market, while weak, is beginning to show signs of stabilization.
- The US economy still appears to be growing. Private sector payrolls rose by 137,000 in September, a respectable number. Q3 auto sales were strong.
The Bearish Case:
- Greece will have to default. This could choke off the ability of Spain and/or Italy to issue debt.
- Political gridlock could lead to a collapse of the Euro.
- Falling commodity prices indicate a higher likelihood of pending recession.
- Persistent high unemployment suggests corporate earnings should begin to decline.
- Populist movements may lead to over-regulation.
- Major financial institutions such as Bank of America are still at risk of crippling losses from the sub-prime crisis.
- A recession in the US could slash earnings, making the valuation argument invalid.
On balance, the bullish case seems to have greater merit. Still, significant uncertainty remains around the European debt situation and the US economy, as well as the possibility of slowing growth in China. The valuation argument (stocks are cheap) is extremely compelling, but tends to mean little when thinking about short term periods like the next six or twelve months. When thinking longer term, it is hard not to be excited about the prospects for stocks.
Volatility is likely to remain heightened for the foreseeable future, but we believe it would be a mistake to try and time equity exposure around it.
3. The US Economy
Many believe it is certain that the US will dip back into recession. However, the economy has been resilient and recently has recently shown more signs of improvement than decline. Recession remains a very real possibility in the next few quarters, but we are optimistic the economy will maintain modest growth before picking up somewhat next year. Here are some of the more important recent data points:
- Q2 US GDP growth was unexpectedly revised up to 1.3%. While not a great absolute number, this proved wrong the increasingly common view that the economy is already in recession.
- Private sector payrolls increased by 91,000 in September. Again, not a fantastic absolute number, but not bad either.
- Auto sales rose 2.5% from the prior quarter.
- Shipments of non-defense capital goods were up 2.8% in August.
- Average hourly earnings were down in August, but rebounded in September and were up slightly for the quarter.
- On a disappointing note, worker productivity was down in the first and second quarters. Third quarter data has not been released.
- Based on the Case-Shiller Home Price Index, housing prices rose in July (most recent available data) for the fourth straight month, but remain down year over year.
4. Cracks in the Great Wall – an Update on China
Incremental negatives in China have begun to surface. China will not be able to maintain growth close to 10% for much longer, if at all. How it slows is important.
The country has never held itself, or its companies, to the same accounting transparency as the West. As a result, investors were temporarily spooked after finding out the US Department of Justice was investigating accounting irregularities at Chinese companies. The investigation is allegedly into smaller firms, but the scare led to double digit intraday down moves for more well-known companies like Baidu and Sina.
Evidence of more tangible cracks in the economy has also emerged. There are reports of private business shutdowns in Wenzhou due to tightening credit, and the HSBC Purchasing Managers Index showed a reading below 49.9 in September. This is the second consecutive month it has read below 50, indicating contraction.
While none of these factors are positive, we view them as warning signs, nothing more. It is too early to declare a “hard landing” in China. Also, growth expectations for China have already declined, meaning much of a future slowdown is probably already reflected by capital markets.
US Presidential Election
As the 2012 elections approach, Obama looks increasingly like a one-term president. Growing frustration with the economy and unemployment has caused a steady decline in approval ratings. Moreover, his lack of any major agenda items or political successes has coined him a do nothing president. We believe the election is the Republicans’ to lose, although Obama still stands a good chance if the stock market recovers and/or unemployment improves.
The current list of Republican candidates is mediocre at best. New Jersey Governor Chris Christie looked like a strong potential frontrunner, but his decision to officially opt out brings us back to the usual suspects—all seem to have electability challenges. Mitt Romney is likely the strongest of the group, but many believe him a political flip-flopper lacking any true policy conviction. There was early hype surrounding Rick Perry until the Texas Governor proved weak in recent debates. The other two possibilities, Newt Gingrich and Herman Cain, are less likely in our view—although the latter appears to be gaining a decent share of the spotlight. One thing is certain: it’s early and the list of frontrunners can change quickly. It was only last August that Michele Bachmann looked hopeful after winning the Iowa straw poll. At this point, we would not be surprised to see a new candidate emerge and capture the GOP’s attention.
This begs the question, who and what outcome is best for the market? An Obama reelection would have a fairly benign impact. He has not shown much interest in pushing major policy changes, and a continuation of this trend would be viewed positively. Markets dislike uncertainty. His odds of pushing through major legislation in a second term would be very low as Presidential power typically diminishes in second terms outside of wartime.
Of the GOP candidates, it’s much too early to predict how the market would react. Policy focus and campaign platforms can change dramatically between primary elections and the actual presidential race. Perry could be viewed as a threat given his more radical stances, particularly his hatred of the Federal Reserve banking system.
Regardless of the election outcome, there is a potential positive catalyst in 2012. Historically, the fourth year of an election cycle tends to be positive for stocks. This is because incumbent Presidents don’t push major polarizing policy in election years. This reduces uncertainty. Also, the Fed usually plays along by being overly accommodative. Fed chiefs are appointed by the President, so they want to be seen as an ally of the White House, even if it has a new occupant.
It was a tumultuous quarter in capital markets, and an exciting quarter for Personal Capital as we officially launched to the public. We are grateful to be able to introduce a service we believe represents a step forward in bettering the financial industry, and we look forward to the challenge of continuous improvement. Thank you for your interest.
Bill Harris, Craig Birk, Rob Foregger and Kyle Ryan
The Personal Capital Advisors Investment Committee
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