Staying focused on a particular investment strategy can prove difficult for amateur investors. In the current environment, it is proving difficult for the most experienced managers and is likely no place for a novice, the exception being someone with a twenty year horizon who subscribes to the buy and hold maxim. If you fit that description, good luck. Between Greece, a global economic slowdown, political wrangling in Washington and a failed effort in the recent Operation Twist, even the neophyte investor should be able to understand why the markets have been so volatile. Regardless of domestic challenges, the question on everyone’s mind is whether policymakers in Europe can contain the sovereign debt crisis. In my opinion, the longer they wait, the more likely their situation will deteriorate.
It’s hard to say which is more important in this market. Some are focused on technical analysis while others remain attached to fundamentals. Personally, I am relying more on the former. The S&P 500 remains tightly locked in the 1120 to 1220 range with many indicators suggesting an oversold market. Nevertheless, investor sentiment is indicating a more bearish tone as they are focused on economic data and Europe; neither have produced any news that might spark a rally. In my opinion, there are three primary drivers that could take stocks markedly higher or dreadfully lower; contagion from Greece, our own (U.S.) set of woes, and whether the global economy can maintain its late stage cycle of slower growth.
The latest chapter in the European saga started several weeks ago when the EU finance ministers grew impatient with Greece’s continuing inability to meet cost-cutting targets. Following their discovery of a potential 2 billion euro shortfall relative to the target, finance ministers began discussing the possibility of withholding the next tranche, due in September. The fact that Greece has been living from tranche to tranche could be signaling an imminent end to their fiscal uncertainty. This kicking the can down the road can only go so far; that road is running out of pavement.
Unfortunately, Greece and other peripheral countries don’t have the benefit of devaluing their currency (like the U.S.) since they are part of Europe’s Economic and Monetary Union (EMU). If devaluing were an option, these countries could likely increase exports and consequently, create growth. In its current state, interest rate increases on the higher-debt countries (Greece, Portugal, Spain, and Italy) will continue to test their sustainability. For these peripheral European countries, growth will require fiscal austerity; so far, this has been a rejected solution. Because so many European banks have large exposure to the sovereign debt, a fiscal and growth solution is needed to restore confidence. The longer policymakers delay, global liquidity is at risk due to multinational companies remaining reluctant to spend or hire given the equivocal outlook.
Making matters worse, Greece remains obstinate and has no intention of embracing much needed austerity. To our knowledge, their hugely overstaffed public sector has yet to see any layoffs and their costs continue to rise. European credit default swaps are pricing in the likelihood of a debt default at 98% or above. Rather than risk additional nonessential nations being dragged down, why not let the default happen now? If Greece wishes to restore competitiveness, it should leave the Euro and restructure. For these reasons, I encourage highly liquid equities and debt instruments which trade on domestic exchanges.
All eyes may be on Europe, but that doesn’t mean problems at home have been repaired. The Fed (Ben Bernanke) has changed its mantra from “transitory” to “significant downside risks.” Washington’s super-committee appears to be doing what they do best: creating more reasons not to solve obvious problems. Earlier this week, stocks surged on better than expected economic news. Jobless claims were down and the government revised 2Q GDP from 1.0% to 1.3%. Even housing grew at a faster pace than anticipated.
We expect GDP to stay in this range through the first half of 2012 and reach above 2.0% by Q4. Jobless claims dropped to 391,000 from the previous weekly reading of 428,000. That ostensible reduction looks good on the surface but it does not concur with the latest Nonfarm Payrolls report-which indicates zero growth in jobs. One week doesn’t signal a trend but if subsequent weeks produce analogous results, it is likely that employment is finally reaching a turning point.
Be that as it may, the U.S. is still sorting through the wreckage of irresponsible leadership. Regardless of how Europe mollifies its problems, Washington will soon be forced into austerity. Stimulus has failed since 2009 and politicians are loath to consider solutions that might deny them re-election. Our federal, state, and local government debt has increased from 53% of GDP to 81% today. The Fed may very well have a few bullets left in the near term but political opposition to spending cuts and debt ceiling hikes combined with the need to reduce longer term deficits suggest that going Keynesian is not likely. Furthermore, monetary policy is growing less effective; hence the so called liquidity trap.
The European crisis timing could not be worse as macro economies have slowed in emerging and developing markets. Globally, it appears that we are in what is called the “late cycle” which indicates growth is positive (not everywhere). The economy is not expanding at the expected pace but it remains modestly upbeat. From this point, it is possible that we fall back to a “mid cycle” stage but I don’t believe that is probable. A more sinister outcome is falling into another recession. My opinion is we do neither; rather, we will likely stay in the late cycle mode through next year at or near stall speed growth with little to no momentum.
Leading indicators have been volatile and mixed but remain positive on the whole. The ISM Purchasing Managers Index gauges capital goods orders, manufacturing employment and economic growth. A reading above 50 indicates activity is rising. This metric had been increasing since the end of the 2009 bear market until the Japanese earthquake. In recent months, the reading has been stable but dangerously close to 50. Should this number improve, so too will the very pessimistic consumer. Regardless of where we are in the cycle, multi-national companies continue to hoard cash while consumers are paying down debt. All signs point to a challenging outlook for capital spending and hiring.
In aggregate, the global economy faces a number of momentous challenges. Consequently, investors face their own set of challenges as they are left with a plethora of economic data to ruminate. At current prices, the S&P 500 is trading about 20% below fair value based on low inflation and low bond yields. The existing environment justifies almost 19-times EPS. In spite of what appears to be an undervalued market, the uncertainty in Europe and ongoing bickering in Washington all but eliminate the possibility of seeing that kind of performance in the short term. As a result, I remain cautious on riskier assets, but advocate looking for bargain stocks among financially strong blue-chip companies.
Specifically, equities and debt with strong balance sheets, emerging markets, corporate bonds and some municipals deserve consideration. Companies like AT&T (T), Siemens (SI), Bristol Myers (BMY), Phillip Morris (PM) and Johnson & Johnson (JNJ) provide strong dividends and low relative risk. At current prices, AT&T delivers a 6% dividend yield. With "mobile commerce" picking up steam, AT&T should do well as smartphone sales continue to increase at record levels. Siemens provides investors a 3% yield and trades at a significant discount.
Bristol Meyers yields 4.20% and though they are getting close to a "patent cliff", management continues to bring products to market and the pipeline is quite robust. Phillip Morris is an industry leader, with a rising market share, pricing power, and the ability to benefit from an expanding middle class in emerging markets. The stock, in my opinion merits higher multiples and currently delivers a 4% yield. Johnson & Johnson yields 3.60% and remains one of the best-managed large-cap healthcare companies. They continue to make smart acquisitions and produce new drugs from a rich pipeline that will more than offset patent expirations.
Should the situation in Greece deteriorate, the dollar should continue to rise on the weaker Euro, thus putting more downside pressure on stocks. With a combination of political, economical and policy risks, the argument for remaining conservative is growing stronger. Investing has always been a long term strategy but should never be passive.
Thanks to the ever increasing uncertainty around the world, larger allocations to cash remain a prudent strategy. Be patient before taking on unnecessary risk and keep emotion out of your portfolio. In the meantime, focus on investments that include emerging markets and multi-national companies with strong balance sheets and rising earnings.
Additional disclosure: This information does not constitute a recommendation of any kind. All information contained herein is for informational purposes only and does not constitute a solicitation or offer to sell securities or investment advisory services.