Time for Concern in the Markets?

Over the past ten days, the S&P 500 has lost 10% of its value, with Thursday's slide highlighting renewed fears of a double dip recession and unmanageable sovereign debt loads. We'll briefly recap our assessment of those fears, many of which we have discussed for the past two years, and summarize our stance on managing your portfolios.

The Bottom Line

We're not recommending changes to investment portfolios based on recent news. Your current allocation strategy, derived from our conversations with you about your risk profile, cash requirements, and investment goals, is designed to accommodate these market gyrations. That means in almost all cases you don't have to react to volatility, or change your plans. We respond to volatility by rebalancing across the strong or weak investments to keep your risk-reward profile in balance.

The Recent Sell-Off

Why has the market sold off recently? And how low could it go? In a word, the sell off is due to renewed fears of a double-dip recession. In particular, the concern is that big deficits of sovereign nations may persist and paradoxically could even get worse under austerity plans-which cut spending but in turn dampen the economic growth needed to close those very deficits. At the same time, the market fears that "governments are out of ammo" in fighting the downturn; rates are already low and stimulus spending is probably tapped out, given debt levels.

Our Assessment of Unfolding Events

While we don't try to predict market direction, we do monitor developments. That way, we can better assess probable outcomes and evaluate investment decisions. Here is our stance on the top issues.

1)  Interest Rates and Economic Growth - The era of cheap debt will inevitably end, and with it our higher consumption rates. US Treasury yields have been falling for 30 years, which has fueled above average consumer spending and increasing living standards. With higher debt levels and deficits, the risk profile of the US will likely increase, inevitably driving rates higher over the next decade. The implications:

  • Lower economic growth for the foreseeable future, versus the recent past.
  • Tighter credit markets, forcing companies to manage leverage more carefully.
  • Challenges to ingrained assumptions about consumption and public policy, forcing tough policy choices.
  • Higher probability of inflation longer term, although rates may stay low near-term.      

For a full discussion, see our newsletter from spring 2010. We use this information to help us manage our bond holdings-from issuer diversification to duration management-and to help us stress-test balance sheets of companies in whose stocks we invest.

2)  European Debt - Default in some form is inevitable for certain countries in Europe. The credit markets show high concern for Greece, Spain, Portugal, and Ireland. We think the markets can support restructuring in these countries. Italy would be a larger challenge for credit markets, although we believe it has better cash flow cushion than these others. What the market would not expect, in our view, is higher rates in Germany or a break-up of the Euro. See our summer 2010 newsletter for more discussion.

3)  US Deficits - A downgrade to US debt might cause short term negative reaction but could end up being a "non-event." The key will be getting our fiscal house in order (i.e., a believable road to a balanced budget). If that occurs, the world will likely continue to demand US debt, the most liquid and ubiquitous safe-haven.

4)  Corporate Earnings - Company reports to date have been encouraging and better than expected, but profitability estimates for 2012 may be optimistic. Much of the recent good news may be due to cost-cutting. Longer-term, multiple expansion will have to come from better top line growth, which may be tough in a choppy economy. Still, stocks are not expensive by historical standards, trading at about 11X forward earnings currently.

Closing Thoughts and Recommendation

We continue to recommend that investors avoid taking extreme positions (all cash, or highly concentrated portfolios), even with complex events unfolding. Volatility should be expected as the world works through these issues, but the right investment strategy should be able to guide investors to their financial goals. Adhering to a bearish or bullish prediction on the economy or markets misses the inevitable opportunities and risks that are unfolding in unpredictable ways, and leads to "market timing," with its dismal record. Our disciplined research and rebalancing continues to balance risk/reward with fundamentals and probable outcomes to help our clients meet their long term financial objectives in an uncertain time.

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