Dog Days of Summer

Eric Linser, CFA | July 8, 2010

As we enter the 2nd half of the year, optimism that greeted the year has evaporated and investors around the world are questioning the strength of the economic recovery. European sovereign debt troubles that have surfaced have now clouded views on the sustainability of global economic growth.

So what's going on? It's not just one thing, it's an accumulation of them. Fears of a second recession (double dip) are growing louder making investors feel panicky and afraid to take risks, which rarely bodes well for the stock market. The yield on 10 year Treasuries has slipped to 2.93% after starting the year at 3.84%, a clear statement by investors not wanting (additional) risk.

At the beginning of the year, the consensus was the economy was going to be strong and stocks were going to easily outperform bonds. Investors didn't anticipate the lingering fiscal problems and events that took place in Europe. During the last six months, investors have downgraded their growth expectations, taking stock prices down with them.

Outside of 2nd quarter earnings that companies will start to report over the next few weeks, there aren’t that many catalysts to get stock prices moving up over the summer months. There seems to be more negatives than positives right now. We are in the midst of what is traditionally considered the summer doldrums – a volatile, often-times trendless market that doesn’t offer rewards for the risks taken. Simply put, traders, brokers, money managers, and investment analysts are human. On warm, sunny days, many would rather be vacationing, catching up with friends, or laying by the pool sipping a lemonade. I personally prefer to leave cold San Francisco and spend weekends backpacking in the mountains. So if the stock jocks aren't in the office, that means they aren't as likely to buy and sell stocks nor would I assume they are thinking about the markets while grilling steaks and playing with the kids. Stock trade volume tends to dry up resulting in greater volatility because the transactions that are completed are going to have a bigger impression on the price of the stock. In Wall Street lore, the summer doldrums officially end after Labor Day in September, when mutual fund managers, hedge fund managers, and stock pickers head back to work and are forced inside as their kids return to school.

If you’ve been watching the markets lately, you might have noticed a bit of a lack of direction (well, more to the downside since late April than up). Trendless markets are challenging environments in which to make money. So what’s an investor to do? First, remember that you’re not alone; in trendless markets virtually no one makes any money. And secondly, if you’re trend following, you’ve had to do lots of buying and selling and you’re not making any progress. Keep in mind that these markets don’t last forever. Eventually, some major asset classes will develop a clear long-term trend in which to invest.

There are almost no areas with positive trends right now. The temptation may be to give up on a plan or tweak it a little. But just when you look to abandon a long-term investment discipline because of a short-term period being unsuccessful, it usually starts to pay off and your persistence is rewarded. Sometimes it’s best to stick to your guns and wait out the summer doldrums.

We've seen a lot of data points soften over the last couple of months. New homes sales plunged to a 40 year low in May. Lumber prices are down 43% over the last two months. The money supply has stopped growing. Job growth is anemic. Unemployment benefits are about to expire for millions of people after the Republicans in Congress blocked a renewal -- taking $45 billion worth of annual purchasing power off the table. And the ISI Group's company surveys have moved to a 14-week low as business confidence has waned. These are all signs of a slowdown.

Before we get too wildly bearish, though, I truly believe the economy is slowing down to cruising speed, not crashing. Over the next few weeks, we’ll probably get both economic and earnings data that will show that we’re not going back into recession (assuming we’ve come out of a recession in the first place).

Maybe John Crudele of the New York Post is right when he says, “The good news is that there won't be a double dip. Why? Because the economy has never really recovered in the first place -- it's all one long slog along the bottom of an economic cycle.”

Coming out of the past five recessions (1970, 1974, 1982, 1991, and 2001) increases in the ISM Manufacturing Index, corporate earnings, and consumer confidence all slowed considerably as the economy transitioned from cyclical economic recovery into slower secular economic growth, according to a recent Merrill Lynch analysis.

It's no surprise then, given the turn of events, that stocks don't tend to do much in the second year of recoveries when investors become increasingly worried about the potential for a quick return to recession. We’re now about to enter the second year of this recovery, so it seems that a slippage in the market is just par for the course. Aggravating? Sure, but not the end of the world nor a double dip.

There are some promising signs that the economy is on a growth path. These signs don't get as much PR these days. In short, I realize that with market prices falling so fast lately it's easy to extrapolate out a lot of end-of-world scenarios, but really the picture is not that bleak.

Performance

Big Retreat

The 2nd quarter was one of high drama in the markets. Much of the volatility came from fears of a worsening debt crisis in Europe that threatened to have a worldwide contagion effect. For both the month and the quarter, all major indexes were down. The Dow Jones Industrial Average was off by 3.6% for the month and 10% for the quarter. The S&P 500 declined 5.4% for the month and 11.9% for the quarter with losses in all 10 S&P index industries. The Nasdaq fell 6.5% for the month and 12% for the quarter. All three indexes also closed out the quarter below their long-term trend lines (the 200-day moving average) and registered their worst quarterly declines since the financial crisis (4th quarter of 2008).

For the first half of the year, the Dow was down 5.0%, the Nasdaq was down 7.0% and the S&P 500 was down 6.7% (all inclusive of dividends). To see how Green Valley is doing with our Owl global stock portfolio, visit http://GreenValley.kaching.com.

The 6.7% loss in the S&P 500 (including dividends) in the first half compared "favorably" with the MSCI World Index of 24 developed countries dropping 9.6% including dividends; a 10 % retreat in the Euro Stoxx 50 index of countries using the common European currency; and the MSCI Emerging Markets Index losing 6.1 %. China’s Shanghai Composite Index was down a whopping 26% with dividends. Shanghai shares posted the biggest decline among major markets as China’s government raised bank reserve requirements to the highest level in three years and curbed real estate speculation. Bonds gained 5.3% as measured by the Barclays Aggregate Bond Index.

Growing budget gaps in Greece, Spain and Portugal sent the euro down 15% against the US dollar and commodities (in aggregate down 11%) posted the biggest loss in almost a decade as oil dropped 9% (ending ~$72/barrel).

These results clearly show the heightened concerns in the markets as it relates to sovereign risk, financial regulation and a potential slowing of the economy.

As we closed out the month of June and headed off for the long 4th of July weekend, investors sold off virtually every asset class and the S&P 500 and the Nasdaq both lost more than 5% for the week (June 28– July 2). US markets remained bogged down due to poor data reports on both the employment and manufacturing fronts.

That 5% slide last week pushed the S&P 500 to 12.6 times estimated earnings for 2010, the cheapest since March 2009 when the measure began an 80% rally.

Upcoming 2nd Quarter Earnings Season

Market Valuations

While corporate results have largely exceeded expectations so far this year, worries have mounted about the US economic recovery, which has been hindered by a persistently high unemployment rate, a troubled housing market, Europe's (in)ability to deal with its debt crisis and worries about a possible economic slowdown in China – all nagging questions needing answered.

Corporate earnings for the second quarter will soon be arriving in earnest next week and Wall Street is expecting spectacular growth of 27% in the 500 stocks that make up the Standard & Poor’s index. Growth of 26% is anticipated in the 3rd quarter, and 33% in the 4th quarter of 2010. While these estimates may have to be ratcheted down, they are still implying pretty strong year-over-year growth.

Earnings for S&P 500 companies may rise 32% in 2010 ($81.34) and 17% in 2011 ($95.17), the largest two-year advance since the period ended in 1995, according to the average of more than 2,000 analysts survey by Bloomberg.

Right now investors are ignoring relative values among asset classes, industries, and individual securities (throwing out the baby and the bath water) and reacting to day-to-day signals on the economy. Maybe stock valuations coming down are reflecting the realities of mounting issues that limit the strength and durability of the economy (?), suggesting that the corporate sector as a whole cannot rely on strong-top-line revenue growth to drive profitability.

Upcoming 2nd quarter earnings will tell us if modestly weaker earnings growth is in the cards warranting lower multiples given an increased focus on longer-term secular headwinds. With the recent sell-off, investors are making the conclusion that slowing US, Chinese and European economies will mean that earnings aren’t going to be up to what we had expected.

Technically Speaking

Where does the Dow go now? Where’s the bottom? The Dow broke through its 50 and 200 day moving averages, the year’s previous low on February 8th, and a support level at ~ 9,700. On July 2nd, the market closed at a new low for the year at 9,686 but has since pushed ahead from here. At this juncture, I’m not sure how much the market can go up until we get a good read on announced earnings starting in mid-July.

So for now, the 50 day and the 200 day moving averages are acting as resistance (10,162 and 10,268, respectively). I believe we are in a multi-month correction that could witness several crosses above and below the 50 & 200 day moving averages in a tight trading range between 9,500 and 10,500. Usually this type of correction needs at least 3 months to work out the preceding 13 month rally, implying the market is going to continue correcting into early August.

Remember on its own any single pattern or technical tool or theory is no better than a coin toss! It’s just part of the mosaic process of investing; technical analysis keeps us in sync with the primary underlying trends in asset prices and allows us to identify important support and resistance levels, which provide valuable aids when making tactical rebalancing and reallocation decisions.

Withering Growth

What are the odds of a double dip recession? The probability of a double dip is somewhat elevated but not inordinately so (20% chance?), but it’s not what we expect to happen unless all the lemmings start to follow each other off the cliff.

While the US economic rebound isn’t strong enough to warrant raising interest rates or shrinking the central bank’s near-record balance sheet, what I see is economic consolidation rather than another recession. That is, developed economies will consolidate into low growth regimes as they seek to balance deficits against stimulus measures, employing inflation (via Quantitative Easing) as a stealth tax to achieve this, so no deflation nor a double dip.

Worries of Debt Crisis – Huh?

In periods of risk aversion, investors sell volatile assets and buy securities perceived as havens. These safe havens have typically been sovereign bonds such as US Treasuries. And that is exactly what we are witnessing now. Recently, yields on 10-year government bonds were 1.1% in Japan, 2.6% in Germany, 2.9% in the US and 3.3% in the UK. Based on these yields, real interest rates on borrowing by these governments are very low (1.2%, or less, in the US, Germany and UK). Investors are saying that they view the risk of depression and deflation as greater than that of default and inflation.

What’s oddly funny here is all the worries of insurmountable government (sovereign) debt that’s suppose to be the death of us. However, at present, there’s a gigantic flow of funds into the liabilities of the governments of advanced countries. While some countries can still get into difficulties, it is quite wrong to argue that the difficulties of Greece or Spain entail difficulties ahead for the US, the UK or Japan. The opposite is far more likely -- flight from risk entails flight into something less risky. What is the least (perceived) perilous asset class for investment presently? The answer is the public debt of big advanced countries, like US Treasuries. Go figure!

Bulls versus Bears

In the tug-a-war between bulls and bears, there’s still a fundamental battle raging on. The bulls are no longer talking about a V shaped recovery (U shaped at best); they admit that growth will not be that robust, yet the recent market downturn more than accounts for any amount of slowing. The bears think we are the next Greece about to implode. They expect many more pounds of flesh to be paid by US stock holders. So "take profits while you can" is their mantra. It will be several months before these arguments are settled so expect volatility and lack of clarity to be the norm.

When fear enters the market, then you sell first and ask questions later. Investing is for the long term, so if you can buy high-quality stocks at these prices, you do it. If they’re high-quality companies, they’ll come back.

Maybe we’ve gotten a little too bearish; currently, the S&P 500 is trading at less than 13 times expected earnings for the current calendar year. The last time we saw such low valuations was back in early 2009, in the throes of our economic crisis. But after the sell-off, we witnessed one of the strongest rallies in market history.

Overall, while I believe stocks offer an attractive alternative to long dated government bonds and cash, I feel that a diversified approach with multiple asset classes remains important as investors weigh structural risks in developed markets with investment opportunities in emerging economies.

While company fundamentals look good, the problem is the emotional aspect for investors. The historical truth in the stock market is you want to buy stocks when there’s skepticism and fear all over the place and sell when everyone’s feeling complacent.

In chaotic times like these, I look to the sage Benjamin Graham, CFA (1894-1976), considered the father of securities analysis and value investing. Here are some of Graham’s timeless principals.

• Invest in stocks and bonds only so far as you can live with fluctuations in prices -- “Do you want to eat well or sleep well? That will determine what I recommend.”

• The price you pay when you buy stocks is key -- only buy securities at significant discounts to their intrinsic values.

• Long-term goals demand long-term thinking -- it takes 2 things to make money, having a sound plan and sticking to it.

I have always thought that getting out of the worldwide Great Recession was going to be a long slog. Given the worldwide headwinds we face, it’s my view now that the 2nd half of 2010 will remain volatile – until we get more tea leaves that portend a re-strengthening in the economy again, or not.

Corrections seem to feel like the end of the world, leaving many with a sinking feeling that can precipitate rash decisions. Times like this make it clear that the equity risk premium is no free lunch and volatility is gut wrenching even for the most long-term of investors. As Benjamin Graham would say, know what you own and why, and have fortitude – it helps me put things in perspective.

Stay healthy, wealthy & wise,

Eric Linser, CFA

Chief Investment Officer

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