Volatility in the Economy and the Markets: What Do We Do Now?

Last week was an unbelievable one. To make sense of it, we have two issues with which to deal:

(1) The Economy: Investors have suddenly [to be specific, this all began on Tuesday] started worrying that inflation is increasing and that will lead to higher interest rates. The problem is that there are two schools of thought on why this is happening: one says the economy is getting weaker but inflation is rising; the other says the economy is getting stronger and inflation is rising. [?] The fact that the pessimists can’t even get the story straight, we think, is an indication that this Market decline is more about stock prices being over extended than anything to do with the inflation or interest rates.

But for the sake of argument, let’s stay on the economy. We knew from the economic data points that we were receiving during the first quarter that it was going to be a bust--we knew it. The good news is that in the last month, the data depicting economic growth has improved markedly while the forward looking inflation indicators have pointed to declining price pressures. Nevertheless, in our opinion, there just isn’t enough evidence yet to have confidence that a rebound in definitely occurring.

Given that--the low growth/high inflation pessimist group have a point that the economy is in the doldrums; and the high growth/high inflation group have a case that recent statistics point to an improving economy. However, neither have a very good argument for rising inflation because both domestically and internationally the data show declining price pressures; hence, their case for higher interest rates, in our opinion, is lacking. The only argument for higher interest rates that we can come up with is that the high growth scenario will generate upward pressure on real interest rates which will serve to lift nominal rates somewhat. Granted that will put downward pressure on stock multiples, but we believe that in calculating equity valuations this will be offset by more rapid than expected earnings growth.

The bottom line is that we don’t see anything in the economic outlook sufficiently disturbing to warrant investor pessimism.

(2) The Market: The Market appears to be telling us that the stock price run which was progressing in a virtually uninterrupted drive to higher valuation levels is over. Since hitting highs on Monday, the S&P, after appearing to break authoritatively above its 2000 high has been smacked down hard, while the DJIA traded below 13400 [its last minor support level] with virtually no hesitation.

The question, of course, is that now that the Market has started to correct having hit an all time high and having been overvalued {in our opinion}, how far will it fall? The best answer we have is to refer to the trends in our Statistical Summary [below] for guidance.

The bottom line, while we are not suggesting a bear Market, is that clearly the rarified atmosphere that has existed since March is no more and we need to recognize that stocks could traded down 15% [we are not suggesting this either] and not break any long term up trends.

What to do now? We think the first thing to be mindful of is staying out of the way of the current volatility--in other words, right now the best thing to do is nothing [unless action is triggered by a Stop Loss]. Second, we need to pay close attention to the stocks that we want to own and be ready to Buy when the Market action improves. Right our Buy List includes Johnson and Johnson (JNJ), Clorox (CLX), Bank of Nova Scotia, Graco (BNS), UPS (UPS), Staples (SPLS), Quest Diagnostics (DGX), Ecolabs (ECL) and Infosys Technologies (INFY).