Stock prices continue to ebb and flow based largely on the news coming out of Europe. It is very hard to discern the ultimate outcome of this crisis, especially with the numerous and often conflicting reports coming out of the region. One day we hear that the Germans will allow the Greeks to default, and the next day Angela Merkel says, in words of Wall Street Journal reporter Marcus Walker, that “Germany remains committed to financing Greece through the euro zone’s bailout funds until Greece can repair its own finances through austerity measures.” What are we to believe?
It seems to me that the ultimate resolution in Europe is likely to be determined by the people and not the politicians. Greek citizens, angry about forced government spending cuts, could doom austerity measures to failure through demonstrations, protest and civil unrest. And if the Greeks are unable to show solid progress toward their austerity goals, the money from the IMF and ECB will stop flowing. German citizens, on the other hand, could throw their politicians out of office due to their willingness to continue to fund the profligate Greek spending. If hardline replacements are elected in Germany, Greece is unlikely to get their promised bailout money. So who will bend first, the German people or the Greek people?
But there is a third party involved: China. China is uniquely positioned to help due to its $3.2 trillion in reserves. In addition, China has a strong vested interest in seeing Europe stabilize and ultimately prosper. In recent days the Chinese have talked more about their willingness to help, and this should come as no surprise. It must be stressed that China is not doing this out of the kindness of its heart. The most important reason for a possible Chinese intervention is that Europe is one of the country’s largest export markets. In addition, the Chinese have been looking for a way to diversify their reserves away from the US dollar. But aside from those obvious benefits, it appears as though China will seek, according the Wall Street Journal, “‘market economy’ status, a technical designation that would provide more favorable treatment in certain trade disputes.” And needless to say, if China does come to the rescue it will require that the Europeans get their fiscal houses in order as a precondition to any future help. We suspect that if needed, the Chinese have too much at stake to stand by and watch Europe go down the drain.
The recent sell-off in stocks is due to fear that 1) we may be entering another recession; 2) we may be about to go through another Lehman-style financial panic driven by the European sovereign debt problems; or 3) both of the above. While either (or both) is entirely possible, we also believe that the damage could be limited this time around. On the question of Europe, we believe it makes sense to assume that the Chinese will intervene before a financial contagion hits Europe. We cannot say in what form the aid will come, but we believe China must act before things spiral out of control. Moreover, the Europeans have not exhausted all potential internal solutions to the crisis. While the issuance of Eurobonds may be politically infeasible and also may not be the panacea that some hope, this option could be implemented if needed.
On the question of economic recession, we also believe the risks may be limited. We view the recent economic weakness as a continuation of the financial crisis rather than a new recession. Therefore, we are already at recessionary levels for key economic indicators such as unemployment, capacity utilization, inventories, and housing prices. Further declines from today’s levels are likely to be much more muted (fingers crossed). In addition, the banking system is much better capitalized following several years of capital raises. And finally, corporate America is in strong financial condition, and stock valuations are much more attractive than they were at the beginning of the last recession/financial crisis. Each of these issues is likely to limit any potential decline in economic activity going forward.
Which brings us back to the question of stocks. As noted above, stocks are now pricing in some probability of either a recession, a European meltdown, or both. While earnings estimates for next year are undoubtedly too high, the S&P 500 is now trading at a bit over 11x the consensus estimate for 2012. If we haircut next year’s estimates by 30%, the multiple rises to 15x – not far off the long-term averages. But even more importantly than these multiples is the question of relative valuation. Many large-cap blue chip stocks offer dividend yields far in excess of the yield on the 10-year Treasury note. These companies generally have outstanding balance sheets with moderate debt and high levels of cash. A long-term investor opting for a 10-year Treasury note over these types of companies must believe that earnings and stock prices will not grow over the next 10 years. Do you believe that?
We continue to see a long period of slow economic growth while the economy delevers and recovers from the worst financial crisis since the Great Depression. But as noted above, slow growth is not necessary the death knell for stocks. The most important consideration for stock performance is valuation (price/earnings multiples) at the time of purchase. We view high-quality, blue chip stocks as attractive on this basis for long-term investors. Stick with quality and you will be rewarded over time.