We are becoming more constructive on the markets. The lack of new negative economic or political news, growing negativity on the part of investors, market volatility without a renewed decline, along with the passage of time since early August are all positives in our opinion.
In hindsight, stock and bond-market investors, including professionals, were spooked during the third quarter by Standard & Poor’s decision to downgrade the U.S. government’s debt rating, the Congressional debate over raising the government’s borrowing limit, and by the Federal Reserve’s decision to leave interest rates near zero until 2013 to combat slowing economic growth. Debate among European policy makers about how to solve deteriorating government finances and whether to add capital to banks also sparked fears that a misstep could lead to a new financial crisis.
Panic spread quickly after the market fell through the price ranges it had established early this year, as shown on the chart below. The S&P 500 Index dropped 14% during the quarter as investors’ dumped stocks and mutual fund holdings. This was the worst decline since the fourth quarter of 2008, yet most damage occurred during just 3 trading days, shown by the arrow on the chart below, during which the market fell by over 10%. Stocks since have fluctuated wildly in a whopping 12% range as seen below, not including an unsettling collapse on October 4 that was reversed on the same day. Composite market prices are now near levels experienced during the summer of 2010.
As prices declined and fluctuated, attitudes turned extremely negative, perhaps because investors’ feared a continued decline, such as occurred during the 15 months from October 2007 through March 2009 when the market lost 50% of its value. For example, the chart to the left shows how active professional money manager’s sentiment fell from cautiously bullish to a point where they were borrowing money to short stocks by early October. (Note: Extreme negative sentiment is a highly reliable indicator that we are near a market bottom. The chart shows that professional sentiment was as negative as it was at the 2009 market bottom at the beginning of the chart.)
We doubt the economy and the markets are repeating 2008. Unlike late 2007 and early 2008, corporate America, including the banking sector, is fairly well capitalized and liquid today, and extremely productive judging from profit levels. The housing problem lingers, but is no longer a crisis. Consumers have reduced and continue to reduce their debt. Federal, state, and local government debt is huge and still growing. This problem will probably hinder American growth for a generation as politics takes its course. However, we doubt any big surprises related to debt are likely, except perhaps on the positive side as governments begin to deal with their problems. Europe also seems to be dealing with its debt problems and a Greek default along with possibly even another country would not be a big surprise.
Rather than a renewed recession, as many including ourselves feared for the second half of this year, empirical data suggests that the economy continues to slowly grow. This slow pace, partially due to the lack of tail-wind from expanding public and private debt, may unfortunately turn out to be normal in the future. While not great for us, it might surprise some investors how dependent China and commodities, for instance, are upon the developed world for their prosperity, a developed world that is now growing slowly.
To repeat 2008, investors’ would also need to become even more negative and continue liquidating stocks and equity mutual funds as they have for the past eight months. This can certainly happen. However, after selling stocks and commodities, panic buying spiked the gold price higher to an early September peak as is normal during periods of peak fear. The price has since been falling. Investors also fled to US Treasury bonds, driving yields to historical lows, even lower than at the 2009 market bottom. During mid-September the US government would pay you only 1.7% annually on a 10 year investment. Those investors who took advantage of the government’s offer have since lost 4% of their capital. In contrast, stock dividend yields are now a relatively attractive 2% for the entire market and “earnings yields” (a measure of valuation) are over 8% compared with 2% treasury yields, something that rarely happens and seems to coincide with rising markets in the future. And although corporate profits are far from depressed, many security valuation measures are back to levels seen during the last market bottom of 2008-2009.
Although our economic views changed little during August and September, market sentiment swung surprisingly negative during August. Portfolios declined, although less than the markets. (Equity Income and Long/Short portfolios declined a fraction, as expected, but of course have less upside as fear subsides.) Now, however, conditions are entirely different, as suggested above. Stocks are inexpensive relative to bonds. We see compelling equity opportunities and are cautiously participating. Consistent with the problems our economy faces, we continue to manage market risk, in preparation for any new unpleasant surprises.