May 10, 2010 - Only a Pullback
Last week the stock market, measured by the S&P 500, extended the pullback which began on April 23 to a peak-to-trough decline of 8.7%. Pullbacks are a necessary part of a successful transition from recovery to sustainable growth. Like forest fires, they are painful when they occur, yet without them the forest could not endure. The pullbacks cleanse the excesses that build up during a rally. They impose discipline by punishing speculation, rewarding value, and realigning expectations. They help to form a solid basis of support on which the stock market may advance.
Over the last few weeks we presented our case for why we believed the stock market was due for another 5 – 10% pullback — much like those experienced in the early part of the first quarter of this year and the fourth quarter of 2009. We cited several catalysts for the pullback; however, the one spark that seemed to ignite the selloff was the growing financial stress in Europe. The debt crisis that has engulfed the European Union is the most serious economic and political crisis in its existence. It remains to be seen whether this Greece fire will be put out or if it has spread to Portugal and Spain requiring additional aid. The fact that the Greek rescue plan has been slow to materialize, and does not address challenges in Portugal and Spain, has been seen by investors as a sign that the broader issue of Europe’s debt problem remains unresolved. Some argue that the situation in Greece is similar to that of some investment banks in 2008 whose failure ultimately triggered a global financial crisis.
The challenges Europe is facing are likely to linger and result in a weak outlook for their economies. However, there are important differences between the failure of Bear Stearns and Lehman Brothers in 2008 and Greece’s current trouble meeting financial obligations.
- First, rather than a precursor to a renewed financial crisis, what Greece is experiencing is an aftershock of the financial crisis of 2008-09. The situation is in Greece is akin to what many people and businesses that overindulged during the credit boom are now experiencing. Greece is feeling the negative consequences of the global recession as the downturn has forced Athens to tighten its belt to try to make ends meet while restructuring its debt. That is what happens at the end of a credit crisis and recession, rather than at the beginning.
- Second, the leverage to the problem is much lower. Similar to many nations, Greece has debt equal to a little over 100% of Gross Domestic Product (GDP). This results in a 1-to-1 leverage ratio. When Bear Stearns and Lehman Brothers failed in 2008 they had about 40-to-1 leverage, essentially multiplying the problem by a factor of 40. In addition, the assets the leverage is based on are completely different. Rather than non-performing subprime loans based on inflated underlying home values held by the investment banks, the assets of the Greek economy are generally productive.
This week, the concerns surrounding Greece and other Eurozone countries should begin to ease as the German parliament approved the rescue package and EU finance ministers unveiled a substantial plan to support the euro over this past weekend. This may lead confidence in the Eurozone to stabilize.
After recommending a defensive posture in recent weeks, we believe the pullback now presents investors with an attractive opportunity to add to stock market exposure. We continue to believe this pullback is likely to be limited to the 5-10% range and not extend into a much steeper decline. Besides the stabilization of confidence in the Eurozone, the next few weeks point to an easing of concerns surrounding many of the factors that may also have contributed to the market pullback.
- In China, new announcements of policy changes intended to slow growth have tended to stoke fears that the sudden withdrawal of stimulus to one of the world’s biggest growth engines may be premature and tip the global economy back into recession. However, the monthly economic releases for China due out on May 9 – 13 are not likely to be accompanied by announcements of additional measures to restrain growth. The late April announcement that Chinese authorities were raising the reserve requirements for banks is being implemented on May 10 and will effectively withdraw 300 billion yuan ($44 billion) from the financial system.
- With the banks still at the center of the healing from the financial crisis, legislation that impacts their profitability or raises the uncertainty surrounding their prospects will likely move the markets. Last week’s voting in the Senate on amendments to the financial reform legislation have vetted out the most extreme proposals. This week we are likely to see a more moderate approach to reform emerge, easing investor concerns about the banks’ prospects and the potential for unintended negative risks to the economy.
- The Federal Reserve (Fed) made few changes regarding its stance on interest rates at its last meeting on April 28. This may ease concerns among market participants about the potential for the Fed to signal coming rate hikes until it next meets in late June.
- While last week many market participants focused on the unemployment rate rising to 9.9% from 9.7%, it merely reflected more people beginning to look for work as more jobs are being created. The same data reported 1.7 million net new jobs have been created so far this year in the United States marking a sharp turnaround from the steep job losses of 2009. As the economy transitions from recovery to sustainable growth, the underlying trend in the data continues to improve with the economic data likely to surprise on the upside.
We expect the current 5 – 10% pullback to be followed by a rally, as was the case in the first quarter. This pullback is likely to be much like the 5 – 10% pullbacks in the last few quarters that acted like the market equivalent of forest fires — cleansing the excesses of growth and fostering the seeds of renewal — allowing the stock market to bounce back to new highs.
While investors last week focused on the few burning trees, the health and sustainability of the overall forest continues to improve with attractive valuations, above-average economic and profit growth, low interest rates, and the return of job growth.
We continue to believe that rising headwinds in the second half of the year — composed of Fed rate hikes, fading stimulus, and slowing global economic and profit growth — may weigh on stocks. However, in the meantime, the current decline is likely to remain only a pullback and give way to a rebound rather than mark the start of another bear market.
IMPORTANT DISCLOSURES: The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
Stock investing involves risk including loss of principal.
The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
Leverage may disproportionately increase a fund’s portfolio losses and reduce opportunities for gain when interest rates, stock prices, or currency rates are changing.
Floating rate bank loans are loans issued by below investment grade companies for short term funding purposes with higher yield than short-term debt and involve risk.
Bank loans are loans issued by below investment grade companies for short-term funding purposes with higher than short-term debt and involve risk.
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