Markets Driven by Psychology

Includes: ERO, EU
by: Charles Lieberman

Greece is too small to matter, especially to U.S. investors. What is driving our markets is the possibility that Greece’s woes will undermine market confidence in Europe and that contagion could spread to infect domestic investors. Memories of 2008 are sufficiently fresh that fears of another meltdown are high, even though economic conditions are considerably improved. We expect growth to slow as a result of the deficit reduction efforts, but mostly in Europe. Domestic demand is still gathering momentum, reinforced by job growth that is boosting disposable income and discretionary spending. Against this backdrop, domestic equities have become quite cheap, once again.

There’s no doubt that Europe has its work cut out for the politicians and the ECB. Greece, Spain, Portugal, Italy, U.K., and others must reduce budget deficits, which will retard growth. Investors question whether the politicians can overcome public opposition to such policy changes, even as much of the public understands how necessary it is to reduce deficits. Investors also question whether such policies will work, because reducing a budget deficit is hard when spending cuts undermine economic growth. The ECB can help by lowering interest rates. The weak euro will also help by boosting exports. Monetary policy in the U.S. is also likely to remain on hold, while European prospects are so uncertain. Investors will remain apprehensive until they can see that these policies can be implemented and that they will work.

Domestically, investors worry that we might get caught up in the maelstrom. If credit availability is impaired, we could experience a headwind to our own recovery prospects. In the meantime, the data suggest that our expansion is building momentum. Hiring has resumed, which will bolster income and discretionary spending growth. Solid domestic economic reports will serve as a strong defense to the distant problems of Europe.

Equity investors hate uncertainty and the turmoil emanating from Europe has undermined confidence, depressing stock valuations. So, stocks are really cheap, trading at 13.9 times 2010 earnings and around 12.1 times 2011 estimates, despite exceptionally low interest rates. Equities aren’t priced for Armageddon, as we were in March 2009, but valuations do reflect a high level of fear and weak prospects. Thus, as conditions stabilize, stocks could experience another sharp upward surge.

Disclosure: No positions

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