“America will always do the right thing, but only after exhausting all other options.”
Sir Winston Churchill
Stock markets around the world have all experienced 10% plus corrections over the last 2 weeks and we would have to go all the way back to the financial crisis post the collapse of Lehman Brothers to find a similar decline. Of course, those wounds are barely healed for investors and their advisors so understandably, everyone is a bit rattled.
The world witnessed the political dysfunction in Washington in the dying days of July as the Republicans and Democrats displayed an unwillingness to put politics aside and come together to craft a meaningful solution to the USA debt burden. Even after one of the large ratings agencies issued a warning in mid July about a possible ratings downgrade on US debt, it was Washington as usual. The result was an inadequate solution to a growing problem. So on Friday night, just a few days after President Obama signed the debt bill into law, S&P followed through on its threat to cut the AAA credit rating on US sovereign debt to AA+ (lower than Canada’s rating for the first time ever). While it looked to me like the markets were pricing in the US downgrade since that warning 3 weeks back, the actual downgrade has continued to drive money around the world into the US bond market. The world has no immediate better alternative to the US bond market and once again, the US 10 year bond is yielding less than 2.50%.
This is the 3rd time that I have rhetorically asked in my market letters as to which “investor” in their right mind would be willing to lend money to the US government for 10 years at a rate lower than inflation? The last time that the US 10 year was this over-valued was last September when the markets became convinced that the US was slipping back into recession and stocks were beaten down over the summer. I wrote in my market update at that time bonds were going to deliver negative returns in the coming months and within just 6 months, those 10 year US bonds sold off and their yields were up to 3.75%. It feels like we are all in the movie Ground Hog Day, as we keep replaying history, cycling back and forth from normalcy to outright fear and everyone is getting exhausted by the rapid gear changes.
So while the media focused on a US debt default which was highly unlikely, the markets began to price in the probability of a cut in the US debt rating which would be the result of Washington “punting” rather than “kicking the can down the road”. And, on the day that they debt deal was working its way to the White House for President Obama to sign, a very weak reading on the US economy was released and spoiled what otherwise could have been a relief rally last Monday. Also, the US revised sharply lower its first quarter GDP and all of this has caused the markets to worry that the USA is hitting “stall speed” yet again. So not only do we have a downgrade in US debt to fret about, we have another soft patch in US economic growth.
Lastly, the on-again, off-again European debt crisis came roaring back last week as the yields on Italian bonds began to relentlessly climb higher. Italy is the 3rd largest debtor in the world after Japan and the USA so rising yields on their bonds also spooked the markets. The European Central Bank (ECB) seemed to be perennially behind the curve at addressing these developments due to the disjointed leadership of Europe showing signs of internal strain.
So all these very recent developments have created a crisis of confidence in the markets and confidence is to markets like air is to humans and you only miss it when it is gone. At the moment, markets have lost faith in their political leaders and their abilities to navigate the post credit crisis world. Watching the debt negotiations in Washington has understandably shaken not just Americans while at the same time, European leaders don’t seem to have the shared motivation and sense of urgency to tackle the European debt problems with the needed bold moves. However, just this weekend the ECB announced that they would go into the market and buy Spanish and Italian bonds to drive prices up and yields down and hopefully drive the short sellers out of these bond markets and restore some confidence before it is too late.
The last couple of days have been absolutely nauseating to watch just like in the fall of 2008. At the moment, fundamentals do not matter as fear is once again back behind the wheel. The selling is indiscriminate with over 90% of stocks being oversold within just a handful of trading sessions. It does not matter which stocks you own, they are all on sale right now and if we don’t slide back into the second Great Recession, then there are tremendous values to be had.
What is perhaps most frustrating about all of this is that we don’t invest in US or Italian debt but rather in companies and corporate profits this earning season have been on balance, the best ever reported with the majority of companies beating revenue and earnings expectations at a time when the US economy was supposedly hitting the skids. Companies are absolutely in the best shape they have ever been with the 500 largest stocks in the USA hoarding more than $1Trillion in cash on their books. You may have read that about a week before the US was going to run out of money, Apple’s $80 billion cash hoard alone was more cash than what the US government had left in the bank! The S&P500 is now trading at less than 13 times earnings when it should be trading at much higher valuations when we consider the very low interest rates and relatively high dividend yields. Many stocks are yielding much more than the 10 year US and Canadian treasury yields and it is pretty likely that many companies will raise their dividends several times over the next 10 years while bonds do not have that possibility.
So if cheap valuations and attractive dividend yields are not enough to get the market moving in the right direction, what is? Sadly, I think it all comes down to government policy decisions that are needed to restore market confidence because that has been the spark each time the markets’ mood sours. I think talk of another round of Quantitative Easing (which will likely be called something besides QE3 for political reasons) will be forthcoming out of the US Federal Reserve very shortly. It is nothing more than a liquidity pump that drives cheap money into the capital markets but it has proven to be rather useful in providing support and stability when the markets don’t seem to be able to find their way forward. And I think it is very likely that the US will announce a deal for companies to repatriate corporate cash sitting overseas back to America on favourable tax terms. Some of that cash will find its way into dividend increases and share buybacks. It seems probable that there will be strings attached to this deal that will require US corporations to deploy some of the cash into jobs and capital expenditures to lend the economy a boost.
Another potential catalyst is China which is very close to the end of its monetary tightening and if the country has successfully orchestrated a soft landing (where growth continues at a more moderate pace of say 6% with less inflation), the markets should respond favourably. And hopefully, the disjointed leadership of Europe will find the political will to coordinate a meaningful and sustainable workout of their debts that keeps the Union in tact. The announcement of their version of Quantitative Easing (where the central bank buys bonds in the open market to drive yields down and inject capital) is a good start.
As you can tell, I am looking for the opportunities in these turbulent times rather than panicking and selling good stocks at depressed prices. I do not think this is a replay of the meltdown that the markets experienced 3 years ago and I think the markets have once again, over-reacted to the downside. As always, call anytime if you would like to speak about your portfolios!