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“It Will Fluctuate” October 13, 2011
J. Pierpont Morgan’s reply, when asked what the market will do, is regarded as the safest prediction. This year the market’s increased volatility has been driven by continuing worries about the possible contagion of the eurozone banking and debt crisis and concerns about the slowing global economy.
Bond and stock prices have been volatile as investor sentiment has shifted back and forth. Interest rates remain low, and stock prices have been volatile, moving in a trading range since early August with advances and declines of more than 1% becoming daily occurrences and frequent moves of more than 2%. The last time we saw this kind of volatility was during the financial crisis in March and April of 2009. According to Bloomberg short-selling and short-covering have been at the highest rates since 2006.
Some of the blame for the spike in volatility can be attributed to the growing dominance of short-term trading activities including high-frequency trading, quantitative computer-generated programs and the impact of hedge fund trading. The S&P 500 Index declined by 14% in the third quarter, zigzagged with wide price swings, and was off by 10% for the nine months ending September 30.
Markets are getting little encouragement from their leaders. Secretary of the Treasury Timothy Geithner says that a world-wide recession is a dominant concern and Fed Chairman Ben Bernanke echoes his view that the economy is close to faltering, but neither offer any programs to inspire confidence. The Congressional super committee is working on a mandated program to cut the deficit while the Administration is proposing tax increases to fund a jobs bill.
European equity markets are down 25% from the 2011 peak. Investors are anxiously awaiting action on the French-German pledge to get the proposed European Stability Mechanism ratified and funded by the end of October to recapitalize the banking system and contain the debt crisis that first erupted more than two years ago.
The stock market is more volatile than company revenues and earnings. Earnings season for third quarter reports started this week with consensus expectations that companies in the S&P 500 will show a 13% year-over-year gain for the quarter. Earnings for the second quarter were reported at $24.86 per share. If current estimates for $106 per share over the next twelve months are correct, stocks are selling at 11 times earnings, well below the historical average of 16.
Investor expectations are low with the steady stream of negative news reports and increasing worries of recession that might lead to lower margins and earnings disappointments. There are times when stock prices tend to become disconnected from corporate performance. This is a time when it looks like the market is pricing in the likelihood of a recession. Despite the well-known risks, our perspective is that a recession will be avoided and that individual stocks with good prospects for sustainable earnings growth are undervalued.
Equity valuations are now at about the same level of three years ago at the time of the Lehman bankruptcy, with the financial crisis and the recession still ahead. While many problems still persist, by almost any measure conditions today are much better. Many U.S. and global corporations should continue to prosper and the current volatility in the market provides opportunities for investors who have the patience to stay the course and take the longer view.