Commentary 9/23/2011

The stock market routs that come about every two months this year came a couple weeks early this time. Two figures put the market’s position in perspective. We are roughly 20% below the highs experienced earlier this year. Nevertheless, we are at about the same level we were exactly one year ago. The ups and downs of the markets certainly wear on the nerves, but the volatility is not destroying fortunes as it was a few years ago. Properly allocated portfolios are weathering the storms and are poised to benefit from undervalued assets.

We can reasonably say most equity-like investments are undervalued for a few reasons. Price-to-Earnings (PE) ratios of the different market measures are relatively low. There is no question that they are lower than they were this time last year when the market was at the same level. Of course, PE ratios are very subjective. A PE ratio compares the price of a company’s stock, or in this case a stock market index, to the company’s or index’s earnings. If the PE is low, we can buy the earnings cheaply – the market is cheap. What makes PE ratios subjective is the earnings part. We can observe the price at any time. Earnings can be estimated or historical earnings can be used. If you look at Robert Schiller’s cyclical PE or PE calculated on earnings over a full economic cycle, about 10 years, the market is fairly valued. The problem with this measure is that it includes earnings from the worst recession in 80 years. It’s not a stretch to say the low earnings over this period distort this PE measure upwards. Looking at forward earnings, or an estimate of earnings over the next year, PE ratios are low. We prefer this approach. We are trying to look ahead, not backwards.

The most important reason stocks may be undervalued is that economic indicators are positive. It is true that the confidence indexes are negative. The harder numbers, the data that actually reflect economic activity, are more positive. Indeed, consumer spending, the growth engine of the global economy, is positive. Manufacturing continues to register positive data points. Even the latest housing numbers are positive. Certainly none of the data indicate robust growth for the economy. Growth is going to be slow for any reasonable forecast period. However, the positive data is not signaling the recession the markets are concerned about.

The reason for the volatility is as much the realization that our government is not willing to do anything to help the economy avoid recession as it is the actual fear of recession. Market fears have more to do with a crisis of confidence than they do actual market fundamentals. Leaders who pronounce that the government stimulus and Fed policy have done nothing to help the economic situation simply don’t know anything about economics. The people who understand economics are the market participants who move the market hundreds of points when the Fed announces easy monetary policy or the government announces fiscal stimulus. We saw this in 2009 and 2010. These are the same market participants who reacted negatively to the Fed’s dismal forecast for the economy yesterday and the probability that we must now depend on politicians to help the economy.

The good news for the domestic stock investors is that American companies are flush with cash and ready to weather a downturn in the economy. Even the big banks are in much better position to weather market turmoil. The bad news is that Europe has leadership issues that are almost as bad as ours. So far, it appears that the Prime Minister of Germany is willing to spend as much of her political capital as necessary to do what is necessary to keep the currency union together. While many Germans may not agree with bailing out the European periphery, Angela Merkel knows that this is what is best for Germany. (See our 10/1 blog:  )

We consider a Greek debt default inevitable. Volatility in the markets will persist until Greece actually defaults. We believe that the EU and IMF are buying time for European banks to capitalize themselves enough to weather the default. It’s easier politically to bail out countries than banks that were bailed out three years ago.

In our opinion, equities remain a good investment. If the hard economic data begin to point to a recession, our position will change. If it becomes clear that action on the part of the government is necessary to avoid a financial system collapse, we will sell all risky assets because we doubt there is the political will to take the kind of action that saved the financial system in 2008.