The curious case of what didn't happen

Sometimes what doesn't happen is as important as what does.

Over the last three months, several BIG events played out on the world stage:

  • The so-called Arab Spring continued, including a major increase in NATO military action in Libya.
  • A massive earthquake/tsunami/nuclear disaster clobbered Japan.
  • Europe moved closer to financial disaster.
  • American politicians decided to test our safe haven status in the global capital markets by threatening to default on our public debt.

At the same time, a number of smaller dramas were unfolding including the deadliest U.S. tornado season since 1953, the arrest of the head of the International Monetary Fund on sexual assualt charges, and Donald Trump announced he would not run for President of the United States.

With all this earth-moving news, how is it possible that developed equity markets ended the quarter so little changed, at least in local currency terms? Emerging markets took the news a bit harder falling by 2.7%, but that was still pretty tame for such a volatile asset class.

Sometimes what doesn't happen is as important as what does.

 My quest to understand the market's muted reaction led me to the following chart by JP Morgan.

This chart compares what JP Morgan calls the "valuation index" for developed markets around the world. For each country, the grey bar plots the index range over the last 10 years. The burgundy hash mark indicates a particular country's average; the blue diamond represents the level of the index on June 30, 2011. The horizontal axis represents 10-year average for all countries combined.

According to the chart, some countries, like the U.S., Japan and Switzerland, usually trade rich relative to the global average (hence their grey bars are mostly above the horizontal axis line.) Other countries, including Germany and France, generally trade cheap to the global average.

You can click here to get more information on the index and its composition, but for now let's focus on the central message of the chart: valuations are attractive compared to historical levels. In every country, the current level of the valuation index (the blue diamond) is well below the average level for the past 10 years (the burgundy hash). In the case of Japan, it is literally off the chart. Apparently, on reason the markets didn't react to Q2 news was because the bad news was already priced in.

Another likely reason for equity market resilience is that corporations, as a whole, are in really good shape. Take a look at the following charts, also compiled by JP Morgan.

Net profit margins are back to pre-recession levels

After getting crushed in the 2008 recession, profits are back to near-record levels. In fact, if recent trends continue into the current quarter, corporate profit margins will exceed the record set in 2007.

Corporations have a lot of cash

Cash levels are also high. High cash levels may reflect lack of confidence in banks. After all, if treasurers areworried about access to working capital from banks, they are likely to horde cash. One thing is clear, however--with interest rates on cash near zero, it won't take long for treasurers to look for better ways to deploy their cash. We should expect to see more stock buy-backs, inventory building and perhaps even higher dividend payouts (though double taxation issues make dividends more problematic.)

Corporations have cut their leverage

Finally, corporate America has undergone a massive deleveraging. In the depths of the financial crisis, corporate debt was over 6.3 times equity; it is now below 4.9 times. As you can see in the chart, we are currently at the lowest level of corporate leverage in at least 17 years.

Whether the markets can maintain their resilience in the coming weeks remains to be seen. We face significant challenges with debt ceiling negotiations in the United States and potential defaults in southern Europe. Either of these issues have the ability to exert tremendous downward pressure on financial markets in the near future. Just because stocks look cheap today doesn't mean they can't get cheaper--a fact made abundantly clear in the post-Lehman meltdown in 2008. However, if I were pressed to make a prediction (and I hate making predictions like this), I would say the most likely scenario is that corporate profits will continue to grow, employment will continue to improve, and the market will continue to work its way higher.