Poor Economic Data And Europe Loom, But Stocks Look Undervalued

|
 |  Includes: BRK.A, BRK.B
by: John D. Frankola

Last week produced a number of weaker-than-expected economic indicators, the most important of which, the May employment report, jolted the markets on Friday. Job growth for May was just 69,000 versus a consensus estimate of 150,000. The S&P 500 Index fell 2.5% on Friday and has declined 10.0% from its 52-week high on April 2, 2012. Year-to-date returns for the S&P 500 are still positive, at 2.6%. Virtually all of the other major U.S. and foreign indices have fared worse. The MSCI EAFE International Index has lost 7.1% in 2012, and has declined 24.0% in the past year.

While the employment report, coupled with disappointing figures for pending home sales and consumer confidence have raised concerns that the U.S. economy is slowing, most of the current correction has been attributed to negative news from Europe. Worries about the economies of Greece, Spain, and Italy and the major banks within those countries have produced fears that the problems in Europe will spread globally.

If all of this seems vaguely familiar, it is a repeat of the scenario that played out in both 2010 and 2011, beginning around this time of year. The U.S. market suffered steep corrections in both years on fears of a "double-dip" recession caused by Europe. In both years, the recession never materialized, the U.S. economy continued to chug along, and the markets recovered.

While the weak economic data raises concerns, I expect the economy to continue to grow, albeit at a very slow pace. In the first quarter of 2012, GDP grew by 1.9%, a pace too slow to make a significant dent in unemployment. The slow growth in many respects represents a very conservative spending attitude by both consumers and businesses. Despite historically low borrowing costs, individuals and corporations have been careful in taking on new debt, or in some cases, have been unable to do so, due to stricter lending requirements. Some also blame an uncertain regulatory and tax environment for companies' unwillingness to expand.

In the next few weeks, we can expect to hear news of more plans from European leaders to stabilize problems in the eurozone. It is difficult to say if any new actions will help to support investors' confidence. Going forward, the lower euro, which has fallen 15% over the past year, should have a positive effect on the European economy, especially for Germany (Europe's largest economy) which has a large export component.

While U.S. exporters might face some headwinds from a rising dollar, significantly lower energy and other commodity prices should provide a boost to consumers. Crude oil, which was trading above $110 per barrel in February, has since declined by almost 25% to $83.26 on Friday. Lower prices for gasoline can have a stimulative economic impact, as consumers are able to spend on other purchases.

Market volatility, which has been high for the last several years, continues to be an unsettling factor for investors. Extreme volatility has produced a loss of investor confidence in equities, and has caused many to shift from stocks to fixed income, despite record low interest rates.

In this year's letter to shareholders, Berkshire Hathaway (NYSE:BRK.A), (NYSE:BRK.B) Chairman, Warren Buffet, commented that investments such as money-market funds and bonds are thought of as safe. However, he stated, "In truth they are among the most dangerous of assets." After considering inflation and taxes, these investments are almost certain to produce a loss of purchasing power over the long-term.

Buffet also dismissed a second category of assets that will never produce anything, but are bought in the hope that someone else will come along and be willing to pay a higher price. The major asset in this category is currently gold. He also referred to other examples, such as tulip bulbs in the 17th century, and internet stocks and houses during the past 15 years.

Of course, Buffet's favorite asset category is investments in productive assets, which include businesses, farms and real estate. He notes that these investments have the ability to deliver goods and services which will hold their value in inflationary times. Historically, these assets appreciate over the long term and are able to increase the amount of cash returned to investors.

As always, it is difficult to determine the short-term direction of the stock market. However, in looking at the long-term horizon, equities appear to represent the best opportunity for attractive returns. The companies that comprise the S&P 500 trade at a valuation that is just 12.1 times next 12-month estimated earnings and average a 2.2% dividend yield. The expected earnings-per-share growth rate for companies in S&P 500 is 10% for the next 12 months. By historical standards, stocks appear to be very reasonably priced. When considering that money market rates are next to nothing, and the 10-year Treasury bond yields just 1.5%, stocks appear to be offer tremendous value by comparison.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author manages portfolios that own BRK.B.