Save & Invest - Third Quarter 2011
http://www.watermarkasset.com/articles/57/1/Save-amp-Invest---Third-Quarter-2011/Page1.html
By Mark Miller
Published on 10/17/2011
There’s something about the third quarter that brings out the worst in
the markets. This one was no exception...
There’s something about the third quarter that brings out the worst in the markets. This one was no exception. With sentiment levels at pessimistic lows, investors remain focused on three critical areas: the European debt crisis; a slowing U.S. economy and concomitant high unemployment rate; and, the lack of a credible response to events from policy makers here, and in the Euro zone. The market response to the uncertainty was a global sell-off in stocks, and pockets of illiquidity and credit spread widening in the corporate bond market. It may have felt like 2008, but it wasn’t, and therein rests the opportunity.
U.S. stocks started their march toward a three-month decline of almost 14% on the heels of the debt ceiling debate in early August. By the end of September, the S&P 500 Total Return stood at -8.68% for the year. The bigger declines, however, came from small and mid-sized company stocks, down approximately 20% each as measured by the S&P 600 and S&P 400 indices respectively. Fears of a European credit collapse and a global recession drove foreign stocks down -19% for developed countries (MSCI EAFE index) and more than -22% for emerging markets (MSCI EM index).
U.S. Treasury bonds rallied with help from the Fed’s “twist” program. The “risk” trade was off and the “fear” trade was on. The Treasury heavy Barclays Capital Aggregate Bond index gained 3.62% in the quarter and was up 6.65% for the year. Fears of a European credit event left corporate bonds flat or slightly down as money moved into the perceived safety of U.S government debt.
The Greek Problem
The European debt crisis grew, in part, out of the creation of the euro in 1999. In an attempt to increase trade and promote economic stability, the European Monetary Union (EMU) created a single currency and a central bank. In some ways, the structure is similar to our system in the U.S. We differ from the EMU in that they are a “monetary” union and not a “fiscal” union. The financially stronger members like France and Germany can’t typically make fiscal “transfers” to the weaker members like Greece, Italy and Spain.
The creation of the euro led to lower borrowing costs for the weaker members. Unfortunately, that also allowed weaker countries to borrow even more, consistently running budget deficits that were financed with ever-increasing amounts of low cost debt. The 2008/9 recession, along with the restatement of previous deficits, clarified the unsustainable nature of large debt loads. Greece, and to a lesser degree, Italy and Spain found themselves shut out of the capital markets. No longer able to fund their deficit spending, the weaker members turned to the EMU for help.
The summer debate began with a focus on bailing out Greece and ended with the grudging acknowledgment that the country will default on its debt. While policy makers were focused on “saving” Greece, it was becoming increasingly clear that that wasn’t feasible. So, much like the TARP program in the U.S., European leaders shifted focus from saving Greece, to saving the banks that owned Greek government bonds. Even though Greece represents a relatively small percentage of the European economy, its accumulated debt is owned by European banks. A default runs the risk of placing the entire financial system at risk. Investors moved money out of euros and European stocks and headed for the perceived safe haven of U.S. treasuries and the dollar.
Since the end of September, France and Germany have been meeting to design a plan that would allow the European banks to recapitalize in the event of a Greek default. The implicit acknowledgment that Greece will default is a welcome step toward reality. A successful defense of the European banking system would minimize the effects of a disorderly default by Greece or any other weaker member of the EU. The stock rally in the first two weeks of October was enough to recapture all of September’s declines.
Investors will be watching for a detailed strategy by the October 23rd deadline, a date set by finance ministers in advance of the G20 meeting on November 3rd and 4th. Expect volatility to continue, at least through the beginning of November, as the world watches to see if the Europeans can craft a credible solution to their problems. Total value of European bank exposure to the debt of Portugal, Italy, Ireland and Greece: $2.17 trillion.
Muddling through…or not
The U.S. economy has been on a decline since March, though it continues to bounce along a bottom with occasional signs of economic growth mixed in with bearish consumer sentiment, including the lowest reading on “consumer expectations” since May 1980.
If U.S. stocks are not pricing in a recession, they are very close. We’ll learn more as the “earnings season” unfolds and companies provide guidance. As of August 22nd, the price earnings ratio for the prior four quarters was 10.5x. The average during expansions is 14.3x while the average during recessions is 13.3x. From this measure, stocks appear to be undervalued. And, the dividend yield on the S&P 500 stands a 2.2%, about the same as the yield on the 10-year Treasury.
Unlike 2008/9, cash assets on S&P 500 balance sheets are at a record $976 billion, up 8.2% from year-ago levels. Credit quality is so good that despite the soft U.S. economy, the corporate bond default rate has fallen to 1.9%, the lowest it has been since April 2008. The recent move to Treasuries, and the drop in price of corporate debt, appears to have created a significant buying opportunity in corporate bonds, especially high yield.
Policy maker response…or lack there of
Whether in the European Union or the U.S., policy makers are no longer working together as they did during the initial credit crisis of 2008/9. Dr. David Kelly of JP Morgan summed it up best in a recent commentary when he wrote:
“With Europe and the United States teetering on the brink of a possible recession, investors around the world hold their collective breath as doubts about the willingness and ability of policy makers on both continents to act decisively have reached a fever pitch, driving global stock prices lower and sending volatility soaring. So, are investors being held hostage by politicians? In short, yes. But, for disciplined investors with an appropriate time horizon, dislocations in markets in response to the turmoil may represent compelling opportunities”.
Compelling Opportunities
So, where are the dislocations? Corporate bonds remain a compelling asset class. Prices are down, yields are up and defaults are low. International stocks, especially emerging markets, have declined dramatically in price. Over the past decade, emerging market growth has outpaced that of developed markets by almost two to one. And, strong dividend paying companies are providing good yield with the opportunity for growth.
Strategies
Stocks started to sell-off significantly in early August, then dropped another 7% in September. In early October the Dow climbed 1000 points and the S&P jumped more than 8%. This heightened volatility has increased the risk in the market and the risk in the portfolios.
As risk increased, we held off on new equity purchases, and in early August, liquidated 60% of a worldwide equity fund that invests in U.S. and international stocks. We’ve held the proceeds in cash and will continue to do so until we get through some of the policy issues facing the world economies.
Investors appear to be pricing stocks for a “recession-or-worse” scenario. Should equity prices resume their decline, we will evaluate opportunities for selective purchases. In the meantime, our focus remains on portfolio risk, corporate bond holdings and real income. The most attractive sectors are high yield bonds, U.S. large cap stocks, emerging market stocks and our alternatives like the structured notes and equity-linked CDs.
We’re now four years into the resetting of the real estate bubble. Our best guess is that we’re likely about half way through the debt clean-up process. Growth in the U.S. will remain slow, and asset prices are likely to remain low. In this environment, the focus has to be on income and debt reduction with an eye toward the opportunities that only present themselves in a bottoming process. That day is coming, and then the rebuilding will begin.
Mark Miller / Eric Lai / John Wenzel
U.S. stocks started their march toward a three-month decline of almost 14% on the heels of the debt ceiling debate in early August. By the end of September, the S&P 500 Total Return stood at -8.68% for the year. The bigger declines, however, came from small and mid-sized company stocks, down approximately 20% each as measured by the S&P 600 and S&P 400 indices respectively. Fears of a European credit collapse and a global recession drove foreign stocks down -19% for developed countries (MSCI EAFE index) and more than -22% for emerging markets (MSCI EM index).
U.S. Treasury bonds rallied with help from the Fed’s “twist” program. The “risk” trade was off and the “fear” trade was on. The Treasury heavy Barclays Capital Aggregate Bond index gained 3.62% in the quarter and was up 6.65% for the year. Fears of a European credit event left corporate bonds flat or slightly down as money moved into the perceived safety of U.S government debt.
The Greek Problem
The European debt crisis grew, in part, out of the creation of the euro in 1999. In an attempt to increase trade and promote economic stability, the European Monetary Union (EMU) created a single currency and a central bank. In some ways, the structure is similar to our system in the U.S. We differ from the EMU in that they are a “monetary” union and not a “fiscal” union. The financially stronger members like France and Germany can’t typically make fiscal “transfers” to the weaker members like Greece, Italy and Spain.
The creation of the euro led to lower borrowing costs for the weaker members. Unfortunately, that also allowed weaker countries to borrow even more, consistently running budget deficits that were financed with ever-increasing amounts of low cost debt. The 2008/9 recession, along with the restatement of previous deficits, clarified the unsustainable nature of large debt loads. Greece, and to a lesser degree, Italy and Spain found themselves shut out of the capital markets. No longer able to fund their deficit spending, the weaker members turned to the EMU for help.
The summer debate began with a focus on bailing out Greece and ended with the grudging acknowledgment that the country will default on its debt. While policy makers were focused on “saving” Greece, it was becoming increasingly clear that that wasn’t feasible. So, much like the TARP program in the U.S., European leaders shifted focus from saving Greece, to saving the banks that owned Greek government bonds. Even though Greece represents a relatively small percentage of the European economy, its accumulated debt is owned by European banks. A default runs the risk of placing the entire financial system at risk. Investors moved money out of euros and European stocks and headed for the perceived safe haven of U.S. treasuries and the dollar.
Since the end of September, France and Germany have been meeting to design a plan that would allow the European banks to recapitalize in the event of a Greek default. The implicit acknowledgment that Greece will default is a welcome step toward reality. A successful defense of the European banking system would minimize the effects of a disorderly default by Greece or any other weaker member of the EU. The stock rally in the first two weeks of October was enough to recapture all of September’s declines.
Investors will be watching for a detailed strategy by the October 23rd deadline, a date set by finance ministers in advance of the G20 meeting on November 3rd and 4th. Expect volatility to continue, at least through the beginning of November, as the world watches to see if the Europeans can craft a credible solution to their problems. Total value of European bank exposure to the debt of Portugal, Italy, Ireland and Greece: $2.17 trillion.
Muddling through…or not
The U.S. economy has been on a decline since March, though it continues to bounce along a bottom with occasional signs of economic growth mixed in with bearish consumer sentiment, including the lowest reading on “consumer expectations” since May 1980.
If U.S. stocks are not pricing in a recession, they are very close. We’ll learn more as the “earnings season” unfolds and companies provide guidance. As of August 22nd, the price earnings ratio for the prior four quarters was 10.5x. The average during expansions is 14.3x while the average during recessions is 13.3x. From this measure, stocks appear to be undervalued. And, the dividend yield on the S&P 500 stands a 2.2%, about the same as the yield on the 10-year Treasury.
Unlike 2008/9, cash assets on S&P 500 balance sheets are at a record $976 billion, up 8.2% from year-ago levels. Credit quality is so good that despite the soft U.S. economy, the corporate bond default rate has fallen to 1.9%, the lowest it has been since April 2008. The recent move to Treasuries, and the drop in price of corporate debt, appears to have created a significant buying opportunity in corporate bonds, especially high yield.
Policy maker response…or lack there of
Whether in the European Union or the U.S., policy makers are no longer working together as they did during the initial credit crisis of 2008/9. Dr. David Kelly of JP Morgan summed it up best in a recent commentary when he wrote:
“With Europe and the United States teetering on the brink of a possible recession, investors around the world hold their collective breath as doubts about the willingness and ability of policy makers on both continents to act decisively have reached a fever pitch, driving global stock prices lower and sending volatility soaring. So, are investors being held hostage by politicians? In short, yes. But, for disciplined investors with an appropriate time horizon, dislocations in markets in response to the turmoil may represent compelling opportunities”.
Compelling Opportunities
So, where are the dislocations? Corporate bonds remain a compelling asset class. Prices are down, yields are up and defaults are low. International stocks, especially emerging markets, have declined dramatically in price. Over the past decade, emerging market growth has outpaced that of developed markets by almost two to one. And, strong dividend paying companies are providing good yield with the opportunity for growth.
Strategies
Stocks started to sell-off significantly in early August, then dropped another 7% in September. In early October the Dow climbed 1000 points and the S&P jumped more than 8%. This heightened volatility has increased the risk in the market and the risk in the portfolios.
As risk increased, we held off on new equity purchases, and in early August, liquidated 60% of a worldwide equity fund that invests in U.S. and international stocks. We’ve held the proceeds in cash and will continue to do so until we get through some of the policy issues facing the world economies.
Investors appear to be pricing stocks for a “recession-or-worse” scenario. Should equity prices resume their decline, we will evaluate opportunities for selective purchases. In the meantime, our focus remains on portfolio risk, corporate bond holdings and real income. The most attractive sectors are high yield bonds, U.S. large cap stocks, emerging market stocks and our alternatives like the structured notes and equity-linked CDs.
We’re now four years into the resetting of the real estate bubble. Our best guess is that we’re likely about half way through the debt clean-up process. Growth in the U.S. will remain slow, and asset prices are likely to remain low. In this environment, the focus has to be on income and debt reduction with an eye toward the opportunities that only present themselves in a bottoming process. That day is coming, and then the rebuilding will begin.
Mark Miller / Eric Lai / John Wenzel