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Over the last several weeks, investors have been served a grim reminder of the volatility that markets are capable of and are being reminded of the events of 2008. The conventional wisdom is that the markets are reacting to the debt downgrade in the U.S. or the threat of default. As the U.S. debt ceiling talks went down to the wire, the world thought it was going to serve as a catalyst to propel the global economy forward only to have Standard & Poor’s downgrade U.S. debt one notch from AAA.

But to infer that this is what is preoccupying markets would not be correct. To borrow a phrase made famous by James Carville, the chief strategist of the 1992 Clinton Presidential campaign -It’s the economy, stupid. The debt downgrade has been a distraction from the real issues.

The global economy was impacted in the first quarter of this year by the Japanese earthquake, tornadoes and floods in North America and Australia– including flooding in some of the oil fields in Western Canada, and Middle East violence. All of these events combined to act as an economic brake.

Notably, in June the U.S. Federal Reserve downgraded its projections for the economy for the third time this year and stated that the economy could expand “up to” 2.9% in the second half of the year and 3.7% “or less” in 2012. Now, it seems that this would be a nearly impossible outcome of the economy. Thus, the U.S. Federal Reserve has now pledged not to raise interest rates for at least the next two years. This policy change amounts to the Fed essentially announcing that they are out of ammunition on the monetary policy front and the economy remains fragile.

It is not only the Fed that is out of ammunition. Many central banks are facing similar challenges. Therefore, better fiscal policy initiatives with respect to taxes and spending policies are going to have to pick up the slack. However, this is much easier said than done as many developed economies have governments that are running into budget constraints.

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S&P 500 Membership Dividend Yields

Rising energy costs have also been a burden on the economy. In the first quarter of this year, we saw a significant uptick in oil prices which tends to act as a tax on the economy. For the U.S. economy, it is estimated that each $10/barrel increase in oil prices shaves off about 0.2 – 0.3% from GDP growth. However, in recent weeks oil prices have retreated to about $82/barrel and this should help the global economy and especially the U.S. consumer.

The economic weakness should not have come as much of a surprise and for investors who recognized that in the early part of this year stock markets were pricing in overly optimistic expectations, the current market sell off represents an opportunity to buy blue chip equities at very attractive valuations. The S&P 500 now sports a dividend yield of 2.2% and the Dow Jones yields about 2.7%. Many of the largest U.S. blue chips now trade for single digit P/E (Price to Earnings) ratios.

All this while 10 year Treasury bonds have risen in price and now only yield about 2.2% as investors seek safety in bonds. In the last thirty years, it has not been a common occurrence for blue chip corporations’ dividend yields to pay more than bonds while trading for attractive valuations. In addition, most corporations should be able to raise their dividends by about 10% on average, barring a rapid economic slowdown.

The opportunity to build a portfolio of attractively valued companies trading at this level of valuation is seldom afforded to investors. The dilemma is to balance the opportunity set created by this incredible uptick in volatility with the economic backdrop globally. In response, investors have gone from complacency and throwing money at mutual funds and stocks to cashing in their chips and heading for the hills.

Recent data from the mutual fund industry in the U.S. shows that equity and bond fund outflows are significant and money is fleeing into money market funds. Nothing like a nearly 20% drop in the markets to convince them to seek safety. This is perhaps the most repeated and costly error investors make.

Time and again, investors choose to “Buy High and Sell Low”. The time to go slow on stocks and be cautious was earlier this year as many market measures showed that the markets were relatively overbought and investor complacency was high. Most of the talk earlier this year from strategists and individual investors alike revolved around the bullish scenario. Today, it is mostly the opposite. Strategists who were bullish weeks ago are now handicapping the odds of a recession.

The market seems to have quickly priced in a measure of economic slowdown and therefore a reduction in corporate earnings. According to Barclays Capital, during recessions since WWII, corporate profits on average dropped just under 16%. At this point, market expectations have come off and are beginning to discount the recession. Analysts have reduced their target prices for just under 30% of the stocks in the S&P 500.

While stocks are cheap and especially so compared to bonds, investors will continue to watch economic data over the coming weeks with a heightened sense of interest. It is often said that bull markets climb a wall of worry. Right now it seems as if the markets are staring up at one.

Source: Debt Distraction Masks Opportunities In Equities