Is It The End of the World?

Probably not, even though it may feel like it.

What’s Going On

The financial markets have been hit with a steady barrage of negatives.

Europe is still struggling to address the problems inherent in the Euro — namely that they have a currency union but not a political union.

Here in the US the short term budget deficit caused by the Great Recession is being confused with the long term budget problems.

These long term problems are primarily about rising healthcare costs, tax revenues that are too low by historical standards, and to a lesser extent Social Security.

This confusion, combined with a toxic mix of politicians in this year’s Congress, caused a dysfunctional budget process. And this dysfunctional process caused Standard & Poors (S&P) to downgrade US Treasury debt (though that company’s past performance on debt ratings leaves substantial doubt about whether they should be listened to).

On top of all of this, we were already in a slowing industrial cycle directly related to China tightening their monetary policy to bring their inflation rate down.

Reactions

Fear that these issues could push the US and the world into another recession is causing falling stock prices.

Most tellingly, these issues have actually reaffirmed investors’ faith in US Treasury debt as Treasury prices have steadily risen as the negatives have piled up.

Clearly investors do not believe that S&P was correct with their downgrade, or US Treasury prices would be falling, which causes rates to rise.

In fact, since the beginning of the year, the yield on the ten year Treasury bond has fallen from 3.4% to 2.4% as fearful investors sought a safe haven. And most of this decline in rates occurred in the last two months as the debt crisis manufactured in Congress ramped up.

This Day in History

Our research tells us that it is not uncommon at this point in a recovery to have a slowdown, so the current economic slowing may not lead to a recession.

Furthermore, the current recovery is only a little over two years old, and in the last 80 years there have only been two recoveries that lasted less than 3 years. In both of those previous cases, the stock market did correct, but the decline was less than 20%.

Double Dip?

There are good reasons that this current crisis is not likely to be a repeat of 2008.

Households and corporations alike have spent the past few years rebuilding their balance sheets. Corporations have become leaner and added significantly to their cash positions.

This should enable them to weather an economic downturn without needing to make layoffs on a scale like we saw 2-3 years ago.

More Good News

We are also encouraged by attractive stock market valuations.

The current stock market’s earnings yield is around 7%, which provides a much higher return potential than high quality bonds which are only yielding about 2% to 4%.

We also believe that companies will see rising earnings over the next 5 to 10 years. Even though the decade of the 2000s was a poor one for the US economy, earnings of our big corporations still rose by about 60%.

For the decade of the 1990s, earnings rose by over 100%. So it is plausible to believe earnings will rise over the coming decade at least as much as in the 2000s.

What We’re Doing

As has been our experience with large market drops like this one (and large market rises as well), we have learned not to make investment strategy decisions based solely on short term market gyrations, though they can present opportunity.

Our research lead us to reduce stock allocations at higher stock prices in late 2007 and earlier this year. Conversely we will be increasing stock allocations at these now lower prices.

We are paying close attention to valuations as some sectors are not as reasonably priced as others.

We are continuing to emphasize large-cap, high-quality companies as they are more attractive than smaller stocks at current prices and better equipped to endure difficult conditions.

Our focus on international equities is in developed economies as they too, have better valuations when compared to emerging markets, though we are maintaining a position in emerging markets as we anticipate those countries to be the drivers of growth during economic expansions.

Many high-quality US companies are also uniquely positioned to take advantage of the emergence of a middle class in China and developing economies as they expand their operations into these markets.

Given that emerging market stocks have also declined, we may be bringing up emerging market allocations for the first time in several years.