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The Case for Confidence September 23, 2011
The market declined sharply in July with the spectacle of Congressional bickering over raising the debt limit, the ECB floundering amidst a continuing sovereign debt crisis, and an array of weak macroeconomic reports heightening concerns of a recession. Equity markets had staged a steady recovery from the March 2009 low, reaching a peak in early May. Price declines continued in August, especially in Europe where many markets entered bear market territory. The S&P declined 18% from the July high until early August. Markets have been highly volatile, awaiting policy responses that offered hope of ending the malaise.
Investor risk appetite is low with markets pricing in a banking crisis in Europe and increased prospects of a global recession. The weak economic backdrop has generated renewed focus on hopes for bold plans to be announced in the U.S. and Europe to speed up recovery. With Greece teetering on default, the G20 finance ministers and central banks nations have joined the European Central Bank announcing a commitment to “take all necessary steps to preserve the stability of banking systems and financial markets”, but investors are not reassured.
At its FOMC meeting this week the Federal Reserve launched another round of quantitative easing by announcing its plan to undertake what is called “operation twist”. It plans to increase the average maturity of its portfolio by selling $400 billion in short-dated securities to buy long term bonds in an attempt to bring down interest rates even lower and stimulate growth.
You all know that our optimistic case for equities is based on our perspective that the strength in corporate earnings will support higher stock prices. Earnings reported for the second quarter continued in an upward trend and management forward guidance was generally regarded as positive. But investor sentiment has turned negative with investors fearful that the economy is on the verge of a recession and that demand will slow, margins will decline, and earnings will decline from current levels.
It’s a global market and a highly correlated one. Economies of developed and emerging markets have become dependent on each other as the volume of world trade has expanded sharply over the last decade. The largest companies are multinationals with revenues dependent on demand, not only from the U.S. and Europe, but increasingly, from Asia and Latin America.
The interconnectedness extends from economies to markets. A crisis in one part of the world inevitably finds its way from one market to another
Downgrading of the rating of U.S. debt by Standard & Poor’s has not changed the fact that the dollar is the world’s reserve currency. Investors increasingly realize that the Fed’s actions regarding monetary policy and interest rates have consequences affecting economies, currencies, and markets. At the end of August stock markets were all in negative territory, reflecting investor doubts that the Fed’s actions can revive the economy.
According to a Wall Street Journal poll, the consensus of economists is that the odds are one in three that the U.S. is facing a recession which would create global economic, political and market pressures. But that means that the odds are two in three that the economy, while slowing, will not sink into a recession. With the market intensely focused on the downside risks, we believe there are a number of good investment opportunities for long term investors.