Aftermath of a Financial Earthquake

Eric Linser, CFA | Aug. 19, 2011

No, I'm not talking about the reverberations from the Japanese earthquake/tsunami but that of the global stock markets. What we were experiencing yesterday (August 18^th) -- another 4.5% down day -- are the aftershocks of the S&P 500 plunging 6.7% percent on Aug. 8, before surging 4.7%, dropping 4.4% and jumping 4.6% in the next three days. And looking further back, they are aftershocks of the 2007-2008 economic and market turmoil.

The S&P 500 has tumbled 17% from its April high, matching the retreat between April 23 and July 2, 2010 (-16%), previously the biggest contraction of the bull market that began in March 2009. Investors have fled stocks in search of stability and safety knowing now that the economy and consumers are not as strong as they thought regardless of how bad they wanted the market to go up. And, knowing there are no easy policy responses given the political posturing as the 2012 election season heats up.

As the aftershocks rattle us, we feel the next big one could be in the offing. What's the next big one? The disintegration of the eurozone is a tsunami that could drive the US back into recession and put the European economies in reverse drive as well. Somehow it’s never felt like we’ve completely come out of recession.

Ugh, if we didn’t have enough to worry about in our own country, we’re now worried that Europe’s debt problems and lack of political resolve to address it will turn into a global credit crisis.

Even with S&P's downgrade of US federal debt from its esteemed status of “AAA,” Treasuries and US dollar cash reserves are viewed as safe havens, as well as gold as witnessed by it topping US $1,800+ /ounce. A panic flight to safety has pushed the yield on 10 Year US Treasuries to ~ 2% (and temporarily below that level) for the first time in American history, exceeding the extremes of the Lehman Brothers crisis.

Given the interconnected nature of the global economy, it is understandable that investors, and advisors alike, are skittish about the developments in Europe. What no one can answer right now is if enough negativity is already priced into financial instruments? The likelihood that some workable path will be developed leading Europe and the US away from the brink is in question.

Seeing the political wrangling over the debt ceiling here in the US and now the unwillingness of France and Germany to save the periphery countries of the EU, I’d have to say that nothing will happen until they are absolutely forced to deal with it, and that means more pain in the short run – for all. Pulling out Gutenberg’s printing press to start a fresh run of Deutsche Marks isn’t the right answer.

Let me try to be more optimistic. It’s possible that the future may turn out brighter than stocks and credit markets currently indicate. Time will tell. Over time, every pull-back in the markets has led to recovery so time does heal all wounds, but you have to start the clock ticking after the fix is in. The risk is of rapidly deteriorating sentiment becoming a negative feedback loop of weakening fundamentals, inadequate policy response, and a bad ‘market tape’ – so the fix isn’t in yet. Let’s hope Ben Bernanke has some tricks up his sleeve come next Friday, August 26^th and/or that the Plunge Protection Team comes to our rescue.

Right now it’s hard for investors to hear that stocks are cheap or that dividend yields are extremely attractive; investors are selling first and asking questions later. The S&P 500 is trading at 12.2 times 2011 earnings estimate of $93 – the lowest since March 2009. Sure stocks are worth less, but they are not worthless! With a 10 year US Treasury returning ~ 2.0%, there are many stocks offering much better yields – and with much better management than those at the helm of governments.

Technical Support
Seeing as fundamentals are being tossed aside right now, let's turn to charts and technicals. Today (Friday, August 19) we closed at 1,124 on the S&P 500 and 10,818 on the Dow. We are sitting right on top of recent support levels (more or less) -- the low set of August 8^th at 1,119 for the S&P and 10,686 for the Dow set on the 10th. Hopefully, we will see a "dead cat bounce" higher next week. If not, we could see continuing pressure on stocks until we see solid policy responses both in the US and Europe.

What to do?
It’s a good question. Each and every client has their own unique circumstances. We should revisit prior decisions, outcomes, and expectations in light on new environments – those driven by family affairs or market conditions – and, if necessary, re-gearing one’s investments. If you have a properly diversified and asset allocated portfolio, you shouldn’t worry too much (easier said than done) particularly if your investment time horizon is 10+ years out. Having other asset classes in your investment portfolio other than stocks can help mitigate risk.

Your portfolio’s growth, over time, will show this event as a sharp sawtooth of a decline, yet only a small jagged edge, matched by those of advances but by no means making up the overall saw. Already the month of August seems long in the tooth, but we must not forget the nearly 2 years of double digit returns we’ve experienced since March 2009. No, we’re not headed toward a depression and you won’t lose all of your money. If you have the fortitude to stay the course, you’ll see that a few sharp sawtooths of declines in the market mean very little over the long term, especially if you regularly invest weekly or monthly via a 401(k) program or in a similar investment vehicle.

Time Horizons
The attractiveness of the stock market at this moment has a lot to do with each investor’s time horizon.

Long Term
Right now cash, money market funds, and most US Treasury instruments are yielding next to nothing. With the dividend yield on the S&P 500 at about 2.1% or Dow stocks at 2.8%, a truly long term investor can appreciate the appeal of stocks right now just from the dividend standpoint alone, excluding cheap valuations. Factoring in the potential of modest capital appreciation over the next 5-10 years, then you can understand why someone like Warren Buffett is currently buying stocks.

Short Term
Let’s handicap a recession since that appears where we’re headed. A typical recession will lower profits (as measured by the S&P 500) by 15-20% from a recent peak. Investors are willing to pay less for stocks as earnings estimates are reset lower, thus price-to-earnings (P/E) ratios will contract as more investors become risk adverse and unwilling to pay as much for each dollar of earnings. Seeing as many strategists have yet to reset their year-end price targets lower (for both 2011 and 2012), you get the sense that many short-term investors (err, traders) have beat them to the punch line and have sold in August, betting on more downside.

What’s the Right View?
Well both, really. It's a matter of what investment time horizon suits you best. Those with patience and perseverance will do quite well in buying/holding quality stocks on sale for attractive long run returns. Those with the fortitude (yet queasy stomachs) to ride out the short term volatility will do well timing their purchases during these volatile times. Unfortunately when we have clarity as to the path we’re on, “you pay a very high price in the stock market for a cheery consensus” as Warren Buffet has stated.

I will leave you with comments (and a link to the full article) from Nouriel Roubini, otherwise known as Dr. Doom and a permabear. I find his most recent article as fair and balanced and worth a read, and it’s not too long. He succinctly touches upon many of the world’s problems in his article of August 15th, Is Capitalism Doomed?

“Until last year, policymakers could always produce a new rabbit from their hat to reflate asset prices and trigger economic recovery. Fiscal stimulus, near-zero interest rates, two rounds of “quantitative easing,” ring-fencing of bad debt, and trillions of dollars in bailouts and liquidity provision for banks and financial institutions: officials tried them all. Now they have run out of rabbits.”
~ Nouriel Roubini from Is Capitalism Doomed?

I have had many offline conversations and correspondences with clients recently; a couple of weeks of historic market volatility. I thank you for your trust and confidence. Like the proverb, "This too shall pass."

Sincerely,

Eric Linser, CFA

"The roller-coaster ride was unnerving for fund investors who have already endured the bursting of the Internet bubble in 2000, a 57% collapse in the S&P 500 Index from October 2007 to March 2009 and the one-day plunge in May 2010 that briefly erased $862 billion in value from U.S. shares. The debacles, combined with falling home prices, unemployment above 9% and a lack of trust in government to bring down spending, may sour individual investors on domestic stock funds for an additional 3 to 5 years."
~ Andrew Goldberg, market strategiest at JP Morgan Funds, on the scar tissue of investors' wounds

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