The third quarter saw equity markets trade substantially lower from where they began—the S&P 500 index started the quarter at 1,320.64 and ended at 1,131.42, a loss of nearly 15%. On October 4th, the S&P 500 saw an intraday low of 1,074.77, which marked a decline of more than 20% from the 2011 high of 1,370.58 reached on May 2. This level was important both from a technical and psychological standpoint since a 20% major index decline is the metric used to determine whether or not we have entered a bear market. Equity markets have bounced back over the past several days, but it remains to be seen whether we are entering a longer term bear market in stocks or if we are merely experiencing a “soft patch”.
So what has caused this decline in stocks? There are several factors at play:
US Economic Data
The US economic picture, which we have long viewed as being fragile and artificially supported by government stimulus, is showing substantial cracks in its façade. In early August, the US GDP for Q1 was revised down from an initial estimate of 1.9% to .4%, a huge 1.5% move down. Second quarter GDP came in at 1.3%, well below analyst estimates of 1.9%.
While many market commentators at the time pointed to the Congressional budget standoff and the S&P’s lowering of the US credit rating to AA+ as the reasons for the stock selloff, it’s now apparent that the problems run much deeper. Over the course of the quarter, as employment, housing, manufacturing and consumer sentiment data rolled in, it became clear that the selloff was a response to a US economy losing its footing rather than a gridlocked Congress (although that certainly didn’t help matters).
Federal Reserve policy
From our perspective, the stock market rally of the past two plus years can largely be attributed to the stimulus policies of the Federal Government and the monetary policies of the Federal Reserve rather than an organic economic recovery.
While government stimulus has largely dried up after Republicans regained control of Congress in the 2010 mid-terms, the Federal Reserve has continued to implement a monetary easing policy with ever more inventive sequels to the original QE.
These measures include: ZIRP (zero interest rate policy), quantitative easing (versions QE1 and QE2) and POMO (permanent open market operations). While the economy and unemployment rate has seen little in the way of tangible benefits as a result of these strategies (although it could be argued that the Fed’s policies helped stave off a Depression), interest rates remain at rock bottom levels and the stock market has roared back to life. The question on every investor’s mind is whether this is a sustainable burst of energy, or a sugar high that will soon wear off.
If the latter is the case (which we believe) then it appears the stock market has gotten ahead of itself and its bullish trajectory does not accurately reflect the fragility of the economy. Instead of an organic recovery driving the markets, it seems stocks are being buoyed by the Fed’s policies and can only continue moving upwards if the Fed keeps refilling the punch bowl of liquidity. But what happens if the Fed decides to end the party and cease its easy monetary policy—will the economy be able to expand on its own?
Increasingly, it looks like this decisive moment has arrived. When the QE2 program expired at the end of June, the Fed elected not to renew it. Instead of entering into another round of buying bonds with cash, as many investors hoped/expected, the Fed went in a different direction. On August 9th the Fed announced its expectation that it would extend the ZIRP policy through 2013 in an effort to keep interest rates low and encourage lending. On September 22nd, they also announced Operation Twist, an action in bond markets designed to push down long term interest rates on everything from mortgages to business loans, giving consumers an additional incentive to borrow and spend money. This approach was first used in the 1960’s (originally named after the dance craze that swept the nation).
While both of these measures are intended to help support the economy, they failed to elicit the same level of excitement in stock investors as the first two rounds of quantitative easing. We remain skeptical of these policies since, in our mind, the problem is not high interest rates, but rather the desire and ability of businesses and consumers to borrow. If businesses do not believe expanding their operations will be profitable, they will not borrow to do it. If households do not believe they will earn more in the future, they will not borrow to finance home-purchases and consumption today. And if loan and credit officers across the country do not believe the economy and employment will grow in the next few years, they will not extend credit. The problem is not the supply or price of credit (the interest rate), rather it’s the demand for it.
European Sovereign Debt Crisis
Ah, our dear old friend, the problem that just won’t go away, no matter how many summits are organized to exorcize it. It seems we always devote some space to this topic every quarter and this letter will be no different.
The problems in Greece and in other European debt-ridden nations, reared its ugly head again this quarter. However, the focus shifted a bit from the nations themselves to the European banks which hold much of this bad debt on their balance sheets.
The major concern many economists and market participants have is that several of these banks would not survive a Greek default. So, if Greece were to go down, it could create a cascading, domino-like event, similar to what was narrowly averted during the 2008 credit crisis. The prevailing view is that the countries and banks are so interconnected that one failure – a European country or a bank – could potentially bring down the entire system. Of course, nobody knows for sure whether or not this is really the case, but elected officials do not seem interested in testing this hypothesis after witnessing firsthand the economic carnage that was unleashed when Lehman Brothers failed. The trouble, however, is that their constituents do not want to pay for the cost of rescuing Greece or even large pan-European banks.
In our view, this train-wreck will continue to play out in slow-motion for the next several months. The solution has to involve some restructuring of Greek debt, and some mechanism to conclusively stop the damage from spreading to Spain and Italy. We do not hold out high hopes for a speedy resolution though. The outlines of the solution have been known for quite some time, but the relevant political and regulatory actors do not appear to have the will or courage to take decisive action and implement it.
So where does this leave investors?
We think the status quo will continue for the near future: structural headwinds in the US economy will persist and the debt problems in Europe are still a long ways from being resolved. Barring another massive monetary intervention by the Federal Reserve (QE3), we believe stocks will continue their slide lower. If there is a QE3 announcement too soon, we think there’s a pretty substantial chance it will be seen by the markets as a sign of desperation on the part of the Fed. We believe the chance that Congress manages to enact meaningful tax or budget reform, or additional fiscal stimulus, is negligible as we enter the presidential election cycle.
We have seen a few weeks of remarkable volatility within financial markets. Stock indexes have moved hundreds of points in both directions with some regularity. Interest rates, bonds and the FX markets have also seen very sharp moves in each direction. We believe this period of volatility will continue for the next few months as the European crisis grinds towards its inevitable conclusion and signs of stress in China make themselves apparent.
As a result, we continue to recommend a defensive portfolio for clients, with high quality, short term/intermediate bonds and cash making up the bulk of client holdings.
We think there will be an opportunity to buy high quality stocks on the cheap in the coming weeks/months and have targeted a list of companies using the following criteria:
- Large cap, US-based companies that have significant exposure overseas, particularly in developing markets
- Companies that have sustainable, attractive businesses and a history of paying dividends to investors through tough market cycles
- Preference for defensive/non-cyclical industries like consumer goods and utilities rather than banks or financials
We believe that, longer term, investments in these types of companies will perform well. In the short term, they will provide cash flow through dividends, so investors will benefit by being paid to hold these stocks in the event the stock market trades in a flat or negative trajectory.