Following strong gains all year, stocks have hit a bit of a rocky patch. The S&P 500 is down 3.3% in the past four trading sessions (through Tuesday), seemingly sparked by disappointing earnings reports from companies across a wide variety of industry sectors and geographies. These weak earnings reports (along with more cautious management guidance) serve as yet another in a long series of data points suggesting that global economic growth is slowing.
Up until the past few days, however, stocks had been one of the few indicators suggesting that the economic outlook may not be so bad. We have come an incredibly long way since the depths of the market trough in March 2009. Specifically, the S&P 500 is up 109% from the low on March 9, 2009. This year, the index has risen over 12% in the face of dramatic uncertainty. Investors who have chosen to sit out this year’s ride based on a plethora of risk factors (fiscal cliff, elections, European financial crisis, China slowdown, etc) have missed out on some strong gains. Still, the 3%-4% decline in the major market averages over the past few days may prove to simply represent fleeting investor anxiety. The one thing we do know for sure is that nobody really knows for sure.
Given that the stock market is supposed to be a discounting mechanism that should reflect future developments, is it likely that the Dow Jones Industrial Average is flirting with 5-year highs right before we are about to go into recession? The answer is obviously no, but there is another factor that has been introduced into the equation. As we all know by now, the Fed has committed to pumping an unlimited amount of money into the economy through a program that has come to be known as “QE3″, or “QEInfinity”. Invoking the old Wall Street mantra “Don’t Fight the Fed”, investors have become emboldened to bid up stock prices in the hopes that Bernanke & Co. will be there to limit losses in the event of a market swoon. But how long can this faith continue in the face of deteriorating economic fundamentals. Last week we quoted Mohammad El-Erian, who said, “There is a limit to how far and how long prices can deviate from fundamentals….Central banks should be respected. And they can certainly counter air pockets, but not forever.”
Throughout the bull market of the past three and a half years, we have consistently argued the three points (among others, perhaps): 1) aggressive Fed monetary policy is not a panacea for an economy that must undergo a painful process of deleveraging; 2) investors should be mindful that corporate profit margins are likely to revert back to their long-term average over time from current record-high levels; and 3) nobody can effectively time the markets with any degree of precision or consistency. These points have kept us invested, but defensive.
What else have we learned over the past few years? Well, we now know that the Fed and other central banks are heavily engaged and playing a central role in the economic recovery. More specifically, we have learned that these central banks, especially the Fed, are determined to drive stock prices higher, thereby creating wealth that can be spent or reinvested back into the economy. While we do not know if this strategy will ultimately be successful, we do know that these are uncharted waters and that the strategy is risky. An article in the Wall Street Journal said, “While the central bank has helped push borrowing rates to the lowest in years, driving investors into riskier assets such as stocks, it hasn’t been able to translate into gains for the broader economy.” The article goes on to say, “With no immediate end in sight to lackluster sales, some of America’s biggest companies said Tuesday they will ratchet up layoffs, idle more facilities and make deeper cost cuts – measures that could further retard the already-struggling recovery.” Given the apparent impotence of the Fed’s strategy, at least at this stage in the game, one has to wonder if the strategy is worth the risks.
So where are we now? We continue to believe it makes most sense to be defensive but to stay invested. Stocks remain attractive for long-term investors in light of the risks and returns available in the bond market. And there are some economic “green shoots” (read: housing) that give us hope for more robust recovery at some point. However, any responsible investor must appreciate the risk inherent to the Fed’s strategy as well as the other “tail risks” that threaten to derail the progress we’ve made so far. Our old friend John Montgomery reminds us that “If you’re going to panic, you should be the first one to panic.” We are not panicking and don’t see a reason to panic. And so again we say, “Don’t rejoice, but don’t despair”.