A Short-term Panic or Something Worse?
Bill Hackney, Managing Partner, Atlanta Capital Management Company, LLC
The stock market has dropped about 12% in the last 11 trading days—by any historical measure an extremely sharp and swift correction in prices. Is this a transitory panic or the beginning of a new bear market that could drive stocks lower by 20% or more in the months ahead?
To be sure, the economic conditions that sparked the recent market decline are very serious. Most important is the European sovereign debt crisis which has spread from the relatively small country of Greece to the larger economies of Italy and Spain. The fear is that Europe's 2011 sovereign debt crisis is analogous to the 2007 U.S. subprime debt crisis; i.e., the beginning of a debt-fueled economic contagion that leads to another global recession and financial panic. Conditions here in the U.S. have also caused investor concern. Our anemic economic recovery from the great recession appears to be stalling and the political theatrics surrounding the debt ceiling negotiations further eroded confidence in our political leadership (regardless of one's party affiliation).
Our view is that the recent plunge in equity prices is most likely a short-term correction, much like the 15% correction in stock prices which occurred in May and June of 2010. That market downturn, similar to the current one, was sparked by fears of a double-dip in the U.S. economy and a worsening debt crisis in Europe. When the U.S. economy gained steam and the European debt crisis eased, the U.S. stock market rallied in the second half the year. Such a scenario is likely to play out again in 2011.
Our constructive outlook for stocks is based on five key observations.
1) Recessions and severe bear markets usually begin following a period of sustained economic growth and monetary tightening by the Federal Reserve. These conditions don’t exist today.
Think about the market tops that preceded the recessions of 1980-1981, 1990, 2001 and 2008-2009. Each of these periods was preceded by a lengthy economic expansion which produced relatively low unemployment rates and relatively high rates of factory capacity utilization. What's more, in each case, Fed tightening was severe enough to invert the yield curve, i.e., push short term interest rates above long-term rates. Today, the yield curve is very steep and there's lots of slack in the labor markets and product markets. These are not conditions that signal the end of a bull market or economic expansion.
2) While the economies of the U.S. and Europe (about 45% of global GDP) are sluggish, the emerging market economies of Asia, Latin America and the Mideast are sufficiently strong to keep the world out of recession and the stocks of many multinational U.S. companies are well positioned to benefit from global growth.
. About 40% of S&P 500 earnings are derived from revenues outside the U.S. The 35% decline in the value of the U.S. dollar over the past decade has made U.S.-based manufacturing much more competitive on world markets. Together, these two factors have underpinned record earnings growth by non-financial corporate America over the past two years. We expect these forces to continue to bolster earnings in the year ahead. Despite sluggish U.S. growth in the first half of 2011, we expect S&P 500 earnings per share to hit $100 over the next four quarters. This substantially exceeds the peak-of-cycle earnings of $86 recorded in 2007 when the S&P 500 index traded at record levels of 1560, or about 30% above current levels of the market.
3) Stock prices appear very attractive relative to bonds and money market instruments.
The current price/earnings multiples on stocks (estimated to be about 12 times 2012 earnings for the S&P 500) are historically cheap versus competing yields on fixed income instruments. In addition, the current average dividend yield on stocks at about 2% is relatively high versus money market and treasury yields (generally in the range of near zero to 3 %). One of the reasons that bull markets end is sharply rising interest rates reduce the attractiveness of equities versus bonds. And sharply rising rates eventually reduce the growth prospects for the general economy. While we expect rates to eventually rise, they are unlikely to rise sufficiently within the next 12 months to erase the advantage that equities have over bonds.
4) We believe that U.S. economic growth will gain momentum in the second half of 2011.
Part of the reason for the recent economic slowdown is due to transitory factors: the economic disruption caused by the tsunami/earthquake in Japan, floods and tornados in the U.S. and the bite on consumer disposable incomes caused by the spike in energy prices. As the negative effects of these early 2011 events dissipate, the economy should pick up later in the year.
5) In the U.S., the corporate economy is much stronger than the consumer economy and the government economy.
Equity investors need to think about the U.S. economy in three parts—the corporate economy, the consumer economy and the government economy. The corporate economy which drives the stock market is much stronger than the other two. It has benefited from the growth of emerging markets and an economic recovery led by industrial production, capital spending and export growth. (Unlike prior recoveries which are usually consumer led.)
Corporate earnings are at record highs. Corporate balance sheets are generally strong with debt levels modest and cash levels high. Many corporations have used the prevailing low interest rate environment to refinance their debt at attractive rates or borrow in order to repurchase stock. The bad economic news of late has most relevance for the government sector of our economy which accounts for about 20% of GDP. The consumer sector of our economy is in a slow recovery mode. A failure to recognize the differences among our three economies has caused many investors to underestimate the vitality of the US stock market.
We have not changed our equity investment strategy as a result of the recent market turmoil. For the past three years our investment strategy has been based on the expectation that the U.S. economic recovery would be lackluster by historical standards. This has certainly turned out to be the case. Our focus has been on identifying companies and industries which could generate above average earnings growth in a risky, uncertain and sluggish economic environment. This focus has led us to emphasize companies with strong balance sheets and with business plans capable of generating sufficient cash flows to internally finance their operations.
Prior to joining Atlanta Capital in 1995, Mr. Hackney was a Senior Vice President and Chief Investment Officer of First Union Corporation's Capital Management Group in Charlotte, North Carolina. In this capacity he supervised the investment management of over $20 billion in institutional and individual assets. He served as a U.S. Marine Corps officer and retired with the rank of colonel in the U.S. Marine Corps Reserve.
This commentary represents the opinions of its authors as of 8/8/11 and may change based on market and other conditions. Their opinions are not intended to forecast future events, guarantee future results, or serve as investment advice. Accounts managed by Calvert Investment Management, Inc. may or may not invest in, and Calvert is not recommending any action on, any companies listed.
The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither Calvert Investment Management, Inc. nor its information providers are responsible for any damages or losses arising from any use of this information.
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