Why the Sell-off?

The S&P 500 has now declined over 7% from the recent peak on January 19th. This drop has come despite a round of corporate earnings that were largely ahead of expectations. So what gives? We thought we’d take a stab at what’s driving the correction. The following is our list of factors that we believe are concerning investors. These factors reflect the tenuous nature of the “recovery”, and they reinforce the notion that we have a long road ahead of us.

  • Most people are pointing to the sovereign debt “crisis” in Europe as the primary factor for the recent sell-off. While the main focus has been on Greece, there are several other European countries running huge deficits that may pose a problem in the near term. These so-called PIGS (Portugal, Ireland, Greece, and Spain) have seen their borrowing costs rise as investors have become more nervous about their ability to fund their deficits. While it appears the EU and other institutions may be rallying in support of Greece for now, this issue will likely affect the markets for a while. Incidentally, we would note that the US deficits as a percentage of GDP are trending dangerously high as well, and they are expected to remain so for the next couple of years (see last week’s market commentary). In the best case scenario, we are going to need a very painful round of belt-tightening across the globe in order to shore up confidence in these debt markets.
  • Recent housing data suggest that the stabilization in the housing market has been highly dependent on tax credits, which are expected to expire at the end of April. Most notably, existing home sales fell sharply in December after buyers rushed to close purchases before the initial deadline for tax credits. As we look out over the next few months, the tax credits may actually be discontinued at the same time that the Fed is scheduled to discontinue its purchases of mortgage-backed securities. We believe these events could lead to significantly higher mortgage rates and reduced demand for housing. Therefore, we believe investors are beginning to more fully appreciate the possibility of further home price declines ahead.
  • The release of the Obama budget for 2011, covered in last week’s market commentary, instilled fear in many market participants. Large budget deficits for several years into the future have many people thinking that higher taxes will be in the offing. The uncertainty surrounding future tax rates leads to increased reticence among companies to invest in projects and hire new employees. It also makes consumers less willing to spend as they continue to work toward repairing their balance sheets after the loss of $11 trillion in wealth.
  • Although the unemployment rate fell to 9.7% in December, the payroll and weekly jobless claims continue to suggest that employers are not adding workers at anywhere near the pace required to meaningfully improve the employment picture. Last week’s jobless claims rose significantly and this week we remain firmly above 400,000. The notion of a jobless recovery is becoming more widely accepted, which will likely mean more government spending to stimulate job growth in the future. More importantly, however, consumers are less likely to spend if they either have no job or are concerned about losing their job.
  • Yesterday, Fed Chairman Bernanke released the transcript of his testimony intended for the House Financial Services Committee (postponed due to the weather). In this testimony, Bernanke said the Fed would likely soon raise the discount rate, which is the rate that banks pay the Fed for short-term loans. This first baby step toward tightening, combined with the fact that there was a dissenting vote among the FRB with regard to the recent statement about the duration of low interest rates, has investors believing we are incrementally closer to a tightening in policy. Rising interest rates are generally not good for stocks.
  • Investors remain nervous about the impact of new bank regulation. In fact, Obama’s speech about the need to limit the size of banks and reign in proprietary trading was the impetus for this sell-off. The future regulatory landscape remains highly uncertain. Bank business models could potentially look very different in the wake of all the new regulations. In response, banks are stockpiling capital, tightening lending standards and accumulating large amounts of deposits. These actions act as a deterrent to economic recovery.
  • While probably the least significant factor, healthcare uncertainty remains. To the extent that companies do not know what their future costs will be (healthcare AND taxes), they remain reluctant to bring on new employees. For now, it seems that the most onerous components of a tax care bill may be avoided. However, until there is complete clarity with regard to this issue employers will feel pressure to delay hiring decisions.

We hope it is clear that the investors have many risks to consider going forward. Recall that stocks began rising before there weren’t many (if any) signs of economic recovery. This is because the market acts as a discounting mechanism. Investors anticipated the stabilization in the economy and corporate earnings before they actually occurred. Now, investors may be looking out to what the economy looks like in the absence of a tremendous amount of government support. In any case, the 70%+ move in the major market indices (from trough in March, 2009, to peak in January, 2010) did not reflect much appreciation for the aforementioned risks. We believe these risks argue for high-quality, defensive, and reasonably-priced stocks.

Hang in there,

Michael