Déjà vu all over again

Recent declines in the stock market have given many folks an uncomfortable sense of déjà vu. Could this be 2008/2009 all over again?

We don’t think so. Though the political drama and the market’s emotional reaction are very similar, we see several reasons why the current downturn should be taken as an omen of opportunity rather than a harbinger of doom.

Omen of Opportunity

  1. Stock valuations are cheap. With the S&P 500 closing today at 1,119.46, investors are willing to pay $12.50 for every dollar of operating profit produced by S&P 500 companies. This is the lowest valuation since 1989 and compares favorably to the 17.75x multiple in early 2008.

  2. Corporations are enjoying record earnings and record cash levels while at the same time reducing their debt. See our recent blog post The Curious Case of What Didn’t Happen  for an overview of the improvement in corporate financial strength.

  3. The problems in the capital markets are pretty well-understood. In 2008, we had no idea how deep the pool of problem assets was. Since that time regulators have scrutinized the banking system more thoroughly than any time since the Great Depression. It is doubtful we will get surprised by write-downs in asset quality anything like those we saw in 2008.

  4. Investors holding bonds and cash are earning very low returns. If you want to get a sense of relative values, consider the fact that the dividend yield on the S&P 500 is now 2.38% -- 7 basis points above the yield on the 10-year Treasury note.

Of course, just because stocks are cheap doesn’t mean they can’t get cheaper. Valuations are subject to many pressures including investor confidence. This is where the rub comes in today’s market--people are just plain scared. Here are a few things topping the scary list:

  1. The uncertainty of what might happen in future attempts to reduce the federal deficit.

  2. The fallout from Standard & Poor’s downgrade of U.S. Treasury bonds.

  3. Continued uncertainty over the European debt crisis.

  4. Fear of another recession.

Actually all these fears are wrapped up with each other and center on the possibility that they might spark another recession.  This is a legitimate fear. Recessions are what happen when flagging consumer confidence meets tightening liquidity. It’s like musical chairs. Suddenly, the music stops and everyone scrambles for safety.

The danger is that the current market correction could become a self-fulfilling prophecy. Falling equity values could reduce consumer activity and European bond problems could reduce the liquidity in the capital markets. With the 2008 scars still fresh, the latest action is unnerving even for experienced investors. We need to watch carefully to see if economic growth is impaired in the coming quarter.

Regarding the S&P downgrade, most buyers of U.S. Treasuries, including Japan, Russia and France, reaffirmed their faith in the U.S. after the downgrade. For that matter, it is ironic that the downgrade of U.S. Treasury Bonds should spark a “flight to quality” out of stocks and into the very bonds that were downgraded!

Finally, not all is “doom and gloom.” Here are some headlines to help fight the recent market chill.

Good News Headlines

Short-term investors may have overlooked many headlines of positive news around the world. Here’s a sampling of recent headlines:

  • Better than expected jobs growth in the U.S.—The labor market created 117,000 jobs in July. Private sector jobs increased by 154,000 while government workers declined by 37,000. May and June figures were revised upward by a total of56,000 jobs. (Moody’s Analytics, Aug 5, 2011)
  • Robust Growth in Germany Pushes Prices—Analysts see a strong chance that German inflation will head towards 3 per cent by the end of the year against a backdrop of robust growth in Europe's biggest economy. (Reuters, July 27, 2011)
  • Brazil Domestic Demand Still Strong—The Economist Intelligence Unit says economic growth in Brazil surprisingly picked up speed in the first quarter, challenging the government’s efforts to cool the expansion. (EIU, July 6, 2011)
  • Japan Retail Sales Top Estimates—Japan's retail sales rose 1.1 per cent in June, exceeding all economists' forecasts and adding to signs the economy is bouncing back from an initial post-disaster plunge. (Bloomberg, July 28, 2011)
  • No Fear in China—Traders betting on gains in China's biggest companies are pushing options prices to the most bullish level in two years. The Chinese economy is projected to grow by 9.4 per cent in 2011. (Bloomberg, July 28, 2011)
  • Southeast Asia Booms—Southeast Asian markets are the world's top performers in 2011 thanks to strong economic and corporate fundamentals. Thailand's index hit a 15-year high in July and Indonesia's a record high. (Reuters, July 22, 2011)
  • Australian Boom Keeps Rate Rise on the Agenda—The Australian dollar hit its highest level in 30 years in late July as traders looked to the prospect of another rise in interest rates on the back of a resource investment boom. (WSJ, July 27, 2011)
  • NZ Bounces Back—The New Zealand economy has grown more strongly than expected after the Christchurch earthquake, helped by improving terms of trade. The Reserve Bank signals it may raise interest rates soon. (Bloomberg, July 28, 2011) 

Bottom Line

From a valuation point of view, equity markets look attractive. Much of the decline in recent weeks appears to be an emotional reaction to decidedly negative political developments. The federal deficit issues are serious and need to be addressed, but politicians need to show better leadership in the process. The efforts of both parties to use the debt limit for their own political purposes were clumsy and ill-conceived.