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Voting With Their Feet
Jim McDonald Image/Headshot

Jim McDonald
Chief Investment Strategist
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After a steady performance by global stock markets through the first half of the year, the bottom fell out over the last several weeks. The market had been adjusting to slowing economic data, but was then hit by the double-barreled problems of the European debt crisis and the U.S. debt ceiling negotiations. With the focus thus turned to public debt management, investors assessed the performance and competency of the politicians they were relying on to manage this debt – and voted with their feet. With market uncertainty already elevated, the downgrade of the U.S. AAA rating on August 5 became the last straw on a weak camel’s back. The result was a 17% “waterfall” decline in the S&P 500 Index during the 11 trading days from July 22 to August 8.


voting feet - waterfall pricedrops exhbt1
Source: Bloomberg, Northern Trust Global Investments. Observation period: 1/1/1928 – 8/11/2011. Chart Concept: Ned Davis Research.

Since the 1920s, there have been 23 instances of these waterfall declines (a decline of more than 15% over an 11-day period). In eight of these instances—seven in the 1930s and the other in 2008—stocks were even lower six months later. In 14 instances (the remaining waterfall decline is the current one), stocks were higher six months later – by an average of 10.2%. So in most cycles, these declines have turned out to be buying opportunities. However, a significant deterioration in the European debt markets represents the biggest risk that we repeat the 2008 experience (negative returns after the waterfall).

The current environment has likely been exaggerated by computer trading, with estimates that computer driven high-frequency trading may account for up to 75% of New York Stock Exchange volumes so far in August. This volatility makes tactical asset allocation changes especially challenging because it is very difficult to successfully implement policy when markets are moving like they have this week (Monday – down 6.7%; Tuesday – up 4.7%; Wednesday – down 4.4%; and Thursday – up 4.7%). As such, we have chosen so far to hold our tactical asset allocation recommendations at a risk level slightly above strategic norms. However, because we have been citing worries about the European debt crisis for some time, our tactical recommendations include overweighting U.S. equities at the expense of Europe, Australasia and the Far East (EAFE) and overweight to gold. This has added to portfolio performance during this year.

In assessing the potential severity of the current stock market decline, we examined bear market history through the valuation lens of price/earnings (P/E) multiples. As shown in Exhibit 2, there has been a reasonable relationship between the valuation of a market at its peak and the subsequent severity of the declines. Since this analysis is based on trailing earnings, we think it also addresses the common worry about declining future earnings. Most of these other bear markets also experienced earnings declines – and lower valuations at the start of the bear market can help cushion the decline. While stocks had enjoyed a considerable run since the market lows in 2009, corporate profits also enjoyed a spectacular rebound and corporations today are in very strong financial condition. The current market decline began with on operating trailing P/E multiple of 15.5, which history shows to be the fourth lowest of the 12 declines studied. This gives some comfort about the potential depth of a decline. Additionally, dividend yields on stocks are now giving competition to Treasury securities. The S&P 500 is now yielding 2.17%, compared with a 10-year Treasury yield of 2.27%, and more than half of the Dow Jones Industrial stocks yield more than the 10-year Treasury.


voting feet - declines vs. valuation exhbt2
Source: Federal Reserve, U.S. Treasury, Bloomberg, Northern Trust Global Investments. Data as of 8/11/2011. Chart Concept: BCA Research. Current is as of 8/11/2011; “Recent Market Low” is as of 8/8/2011.

Recent incoming economic data has been mixed, showing some continuation of spring’s soft patch, but not recession-like weakness. The global purchasing manager index reports for the manufacturing sector, while clearly weakening, so far have been offset by strength in the services sector. The U.S. labor markets have shown a modest pulse, retail sales for July were up smartly, and this week’s new orders data from Cisco Systems indicated business spending is continuing apace. Our base-case scenario remains that the global economy will continue to expand in 2011 and 2012, and the United States will avoid a “double-dip” recession. But the pace of growth is expected to remain slow, unemployment rates will struggle to fall, and global companies will continue to be dependent on emerging market demand.

In this slow-growth environment, the risk is that further turmoil in the markets will subsequently harm economic growth. For example, the Europeans need to approve the European Financial Stability Fund in September, and any hesitancy in that process or other euro-bond market stresses would likely be problematical. To paraphrase George Soros, the stock market may not predict future economic growth, but it can change future economic growth.

The shadows of the 2008-2009 financial crisis certainly lurk in the back of many investors’ minds. An objective review of the current state of the financial system shows a stronger condition today. Our fixed income investment colleagues, who are witnessing more normal functioning across money markets and credit markets than we saw during the crisis, also corroborate this. As shown in Exhibit 3, eight out of nine financial system indicators are healthier now than in October 2008, and all are healthier than in March 2009. Not only are these indicators an important measure of current conditions, they also are an important component for future economic growth as they represent measures of the economy’s ability to finance current operations and future growth. While European markets are showing some increased strain relative to the U.S. markets, they are also healthier than in 2008 and 2009.


voting feet - stress indicators exhbt3
"+/-" columns indicate whether current environment is more (+) or less (-) healthy.
Source: Bloomberg, Northern Trust Global Investments. Data as of 8/11/2011.

In the wake of the S&P downgrade of the long-term U.S. debt rating, a principal worry was the effect on the benchmark risk-free securities – but the market didn’t blink. This has led to relative calm in the money markets, and we also have seen good performance in the municipal bond market. We think S&P’s indication that state and municipal issuers can have ratings higher than the U.S. government was constructive and, with pre-tax yields in state and municipal bonds near comparable Treasuries, selective opportunities exist. It is also abundantly clear that, in the wake of the Federal Reserve’s announced plan to potentially keep the Fed funds rate unchanged until mid-2013, the short end of the yield curve will stay low. This should provide some incremental incentive for investors to seek out higher yielding debt or other higher-risk investments like dividend-paying stocks.

There will be considerable focus on the work of the Joint Select Committee on Deficit Reduction (charged with creating the specific plan to cut $1.5 trillion in support of the debt ceiling deal) over the next several months. Initial reports on the composition of the selected members show a predictable ideological mix, but both the Republicans and Democrats have nominated at least one member who has shown some historical willingness to compromise. While a real package of spending cuts and tax reform (lowering rates across the board; cutting deductions and loopholes) would be a great tonic for the economy and market, we see little reason for optimism ahead of the 2012 election. Therefore, we expect much posturing and politicking right up to the November 23 deadline before a plan emerges.

Our top concern remains the political outlook for solving the euro sovereign debt crisis. Market worries about the liquidity and solvency of the peripheral countries (Greece, Ireland and Portugal) moved to the systemically important Spain and Italy during the last month. These economies and bond markets are too big to rescue. European bank stocks have followed the value of euro zone debt downward over the last several months, but the recent rally in Spanish and Italian bonds has only very recently started to improve bank stock performance. It is important that we see stabilization in the European banks, due to their critical role in credit creation across Europe. An increasing fiscal union across Europe, despite the political challenges faced in Germany, remains the most likely path to stabilizing credit concerns. Similar to the deliberations in the United States, European politicians are likely to only respond in adequate force and size when they are left with no alternative. As such, we see considerable risk of market volatility while this transpires.


voting feet - eurobonds bankstocks exhbt4
Source: Bloomberg. Data as of 8/12/2011.

The increasing austerity measures being considered across Europe and the United States will be another headwind to growth. As such, monetary policy will continue to be as accommodative as nervous central bankers will allow; in the United States, Federal Reserve Chairman Ben Bernanke is nervous about high unemployment and the risk of deflation, not inflation. We think the risk of recession is reduced because we don’t see many excesses built up across the U.S. economy (housing is on its back, autos are only clawing their way back to replacement sales levels, hiring is sparse and corporate spending is still fairly cautious). In this environment, the wall of excess global savings continues to flood fixed income markets, leading to 10-year yields of around 2.50% or less in countries such as Canada, Germany, the United Kingdom and the United States. Only when investors gain confidence in the European fiscal situation and outlook for global growth will that money start to tire of the low nominal returns in fixed income and start to search out other asset classes with potentially higher returns.

Special thanks go to Phil Grant and Emmanuel Bernabe for data research.

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