Market Commentary
October 3rd, 2011
The Not so Friendly Skies
“Ladies and Gentlemen if I may have your attention, please fasten your seatbelt and hold on for dear life the fourth quarter is about to begin.”
It has been a rough ride to say the least. The quarter started on a relatively quiet note, but as it progressed a number of issues conspired to increase volatility and cause the major equity indexes to register one of the worst quarterly performances in recent memory. In comparison, the worse the news the better the domestic bond market did with the ten-year note reaching levels not seen for over seventy years.
Few markets were spared during this period. The Chinese stock market hit a fourteen-month low as investors questioned the country’s ability to continue to grow, let alone avoid recession. Copper, a barometer of global growth, fell 25% in the month of September[1]. Emerging markets suffered a similar fate if not quite as severe. Here in the U.S. the S&P500 [2] fell 7.0% in September alone and is now down 10.4% for the year. [3]
Even the perceived safe haven plays were impacted. Gold declined 12%[4], the Swiss franc fell as investors booked profits, and hedge funds sold their winners to meet the anticipated wave of redemptions from clients. Only the U.S. government bonds seemed to survive as the Federal Reserve enacted “Operation Twist” [5]. Treasuries rallied as capital inflows continued from risk-averse investors.
“What was responsible for the capital markets precipitous fall?”
Sovereign debt issues continued to reign moving the markets with every headline as European leaders attempted to find some solution to the problem. Unfortunately, to date policy makers are gravitating toward short-term solutions to a long-term problem. While this may provide some support to the capital markets in the near term, it will not correct the structural issues Europe faces. It will only be a matter of time before the specter of defaults for Spain and Italy are raised once again (Greece is for all intents and purposes already in default or at best on life support).
Secondly, recent economic reports out of China have indicated a slowing in the rate of economic growth with some economists calling for a possible recession. The fear of a contracting Chinese economy has been evidenced by the decline in commodity prices around the world from oil to coal to copper. If China were to slow considerably a major support to global growth would be removed, at least temporarily.
In sympathy, emerging markets have fallen with many down over 14%[6] in the recent quarter. Though the emerging and frontier economies are not as closely tied as they once were to the developed nations, further contraction in the U.S. economy and an inability to fix the Euro zone will impede growth and put pressure on their markets.
Finally, here at home, we continue to struggle with ineffective policy, high unemployment, and a housing market that shows little in the way of improvement. While there have been a few bright spots in the economic data, given the amount of stimulus, G.D.P. growth should be closer to 6% not languishing at 1-2%[7] . This alone should indicate the depth of our problems and the need for fiscal discipline and constructive monetary policy.
“With all the negatives is there any hope for improvement?”
Though it is difficult to be positive in light of all the problems we are facing today, there is some hope for a brief respite before continuing the downward trajectory. The caveat is we would not want to increase equity exposure until we see a further retracement in the equity indexes.
From a technical standpoint, the S&P is flirting with levels that could signal further declines, however if that were to occur, a trading opportunity could present itself.
Historically, the fourth quarter tends to be a positive period especially after a significant decline in the third quarter. However, there have been some truly horrific October sell offs, 1987 & 2008 come quickly to mind, but for the most part it can be a time to add risk in portfolios not to reduce it.
Assuming corporate profits can come in near current expectations without significant revisions to future earnings, equities are fairly valued if not under valued. With the S&P at current levels, it is trading at approximately 16.5[8] times normalized earnings. This represents the average multiple for the S&P going back to 1926.
The dividend yield on the S&P is currently 2.26% [9] at a time when the ten-year note is yielding 1.84%[10] A strong argument could be made for multi-national companies that have strong balance sheets, consistent earnings, and a dividend yield in excess of 3%. Also, there could be a rotation out of fixed income (with the exception of high yields that we view as attractive) and into equities as investors view the bond market as over valued and stocks under valued.
Finally, the market has a tendency to do the exact opposite of what the consensus believes. Given that most investors are bearish, it would not be surprising to see the markets rally off the lows. The rally may start as short covering, but could build momentum as money managers fear being left behind going into year end and subsequently increase their equity exposure pushing up stock prices.
“Would a fourth quarter rally alter your view longer-term?”
No, not actually. As we have written previously, we are dealing with global macro issues that were years in the making and in our opinion no amount of policy intervention is going to be able to correct the imbalances in the financial markets and global economies. Until such time as the capital markets are allowed to clear, we believe the markets will continue to vacillate and trade on policy not fundamentals.
The good news is, that once the free markets are allowed to find a natural bottom, we should establish a level from which sustainable growth can occur. It is important to remember that during periods of great financial stress, long-term opportunities are created and out of necessity lasting solutions are found.
“Any last words?”
Always… Though a trading rally may present itself in the coming days, the bias remains to the downside and with it the need to protect capital. Volatility should remain the watchword, but we remain confident that once the policy makers throw up their hands in resignation, the capital markets and the global economies will find a foundation from which to grow.
The process will undoubtedly be painful, but growth usually is and we will continue to do our best in navigating the turbulence until the skies clear once again.
Sincerely,
Brad Griswold
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Sources / Footnotes
[1] Reuters.com
[2] S&P 500 An unmanaged capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries
[3] Bloomberg.com
[4] Marketwatch.com
[5] Operation Twist Name given to a Federal Reserve monetary policy operation that involves the purchase and sale of bonds
[6] Barrons.com
[7] Tradingeconomics.com
[8] Barrons.com
[9 &10] Wall Street Journal