Research & Advice

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The Majority of the Damage Likely Done

Sunday, June 17, 2012

 

 

  • Berkshire Money Management has been telling clients for the last six months that although the frequency of Eurozone-driven news had been reduced significantly compared to mid-to-late 2011 that the information had not changed. It is something we pay attention to much more than other money managers who prefer to always maintain some level of international exposure for the purpose of diversification.

  • In regard to Europe more broadly, our sentiment indicators work demonstrates that when pessimism becomes as pervasive as it has, the market usually rallies on the realization that the outlook is not as dire as investors had feared.

  • In 2012, stocks rallied through the first quarter and into the second quarter before peaking amid concerns over the sustainability of monetary and fiscal stimulus, the European debt crisis, and a hard-landing in China. The same pattern, and list of concerns, transpired in 2011 as well as 2010. In our “Economic Outlook for 2012” report we highlighted our concern for a stock market pullback in the second quarter.

 

Spain’s Bailout

In early June Spain was granted a 100 billion Euro bailout to recapitalize. As recently as last month, Spanish officials were denying the need for aid. The need for the Spanish bank bailout is in line with our late 2011 prediction that there would be a Eurozone crisis in mid-2012. We have been telling clients for the last six months that although the frequency of Eurozone-driven news had been reduced significantly compared to mid-to-late 2011 that the information had not changed. It is something we pay attention to much more than other money managers who prefer to always maintain some level of international exposure for the purpose of diversification. Although the bailout itself is welcome (from a stock market viewpoint), it may not be enough in the long-term; it does not address Spain’s underlying problems, and is missing important details.

The 100 billion Euro bailout is enough, however, for now. The problem is that the situation could worsen. There are roughly 300 billion Euros worth of loans associated with the real estate sector (mostly developers), and almost two-thirds of that (180 billion Euros) have been classified by the Bank of Spain as “troubled”. This, however, does not include over 600 billion Euros in mortgage loans. Housing prices have already declined over twenty percent since 2008 and will probably fall even more, reducing loan values.

 

Europe, More Broadly. As Bad As It Gets?

Our sentiment indicators work demonstrates that when pessimism becomes as pervasive as it has recently toward Europe, the market usually rallies on the realization that the outlook is not as dire as investors had feared. Since last month’s elections in France and Greece, market anxieties have been heightened by the potential for gloomy headlines in June. But so far the month has been characterized by positive news, most notably the Spanish bank bailout that, at the very least, has bought Spain some time and eased fears of an imminent disaster. All is not perfect in Spain, but Spanish equities appear to have lost downside momentum, Spanish banks included. With the Spanish market now extremely cheap, it is likely that investors have priced in the bad news on banks, housing, employment, and the economy in general.

 

Comparing the 2012 Correction to those of 2010 and 2011

 

In 2012, stocks rallied through the first quarter and into the second quarter before peaking amid concerns over the sustainability of monetary and fiscal stimulus, the European debt crisis, and a hard-landing in China. The same pattern, and list of concerns, transpired in 2011 as well as 2010. In our “Economic Outlook for 2012” report we highlighted our concern for a stock market pullback in the second quarter. As 2012’s correction has unfolded, we have received several client questions about whether the decline of this year would be as steep as the previous two years. At the end of 2011, we thought the probability of that was fairly high. However, our indicators now suggest that (with the caveat that a financial meltdown in Europe would overshadow other market drivers) second-quarter weakness will be less severe than the 16% drop in 2010 or the 19% drop in 2011.

The rationale is that having been able to, obviously in hindsight, look at the market-price action post the late-2011 low that the rally was the start of a new cyclical bull market, advancing not only in a maturing US economy but also in a world where the Euro would survive. Compared to the last two years, valuation and economic data are more positive. And while sentiment indicators have not declined to levels of pessimism seen at the 2010 and 2011 market lows (from a contrarian viewpoint, extreme market pessimism is a bullish sign), pessimism is enough to support a bottoming process. Concern and uncertainty have been widespread over Europe quickly imploding, and the “Fiscal Cliff” (more on this in future reports) in the U.S. To be clear, these are fundamental risks that could lead to more downside, but are also now well telegraphed. If these events are not fully realized, the market is likely oversold enough for the bottoming process to give way to an election year rally. We believe sentiment appears in place for a market bottom, barring a less likely significant fundamental turn of events. It appears as if a market bottom was reached on June 4, even if only temporarily.

The valuation backdrop is more positive in 2012 than the last two years. The median price-to-earnings ratio for the S&P 500 started at a lower level in 2012 than in the previous two years, so there was a modestly larger valuation cushion to start with this year. Rising dividends and record-low Treasury bond yields means that the percent of stocks with dividend yields above the 10-year Treasury yield also started at a higher level in 2012, and it has hit a record high of 54%.

Fears of a global recession were integral to all three declines. In 2010 and 2011 those fears proved to be unfounded, with the exception of the Eurozone starting late-2011. In 2012 (as in most any year) there are challenges to the U.S. economy, not the least of which is the Fiscal Cliff which is a concern heading into 2013. But a major difference between now and August 2011 is that last year we were staring over the edge of the cliff, had Congress not raised the debt ceiling.

The European debt crisis spreading across the globe is the biggest risk to the U.S. stock market. Global central banks are better prepared today to act more quickly; in many ways they already have. The U.S. economic expansion is more mature and more sustainable than in 2010 and 2011. Barring a sharp deterioration in economic activity, economic data does not support another major downleg in the popular U.S. stock market averages.

Bottom Line:

As 2012’s correction has unfolded, we have received several client questions about whether the decline of this year would be as steep as the previous two years. At the end of 2011, we thought the probability of that was fairly high. However, our indicators now suggest that (with the caveat that a financial meltdown in Europe would overshadow other market drivers) second-quarter weakness will be less severe than the 16% drop in 2010 or the 19% drop in 2011.

The rationale is that having been able to look at the market-price action post the late-2011 low that the rally was the start of a new cyclical bull market, advancing not only in a maturing US economy but also in a world where the Euro would survive. Compared to the last two years, valuation and economic data are more positive. And while sentiment indicators have not declined to levels of pessimism seen at the 2010 and 2011 market lows (from a contrarian viewpoint, extreme market pessimism is a bullish sign), pessimism is enough to support a bottoming process. Concern and uncertainty have been widespread over Europe quickly imploding, and the Fiscal Cliff in the U.S. To be clear, these are fundamental risks that could lead to more downside, but are also now well telegraphed. If these events are not fully realized, the market is likely oversold enough for the bottoming process to give way to an election year rally. We believe sentiment appears in place for a market bottom, barring a less likely significant fundamental turn of events.

The European debt crisis spreading across the globe is the biggest risk to the U.S. stock market. Global central banks are better prepared today to act more quickly; in many ways they already have. The U.S. economic expansion is more mature and more sustainable than in 2010 and 2011. Barring a sharp deterioration in economic activity, economic data does not support another major downleg in the popular U.S. stock market averages.