Market Comment Q2 2010

The Weight Of The World

After smooth sailing through April, U.S. stock markets ran into gale force headwinds that erased year-to-date gains and then some. The business recovery is continuing, and corporate profits are rebounding very strongly. These facts typically would have the greatest influence on stocks, but instead markets are responding to the rest of the news where it seems that whatever could go wrong has. The ongoing oil flow in the Gulf of Mexico in some ways might be viewed as a metaphor for issues around the world that seem beyond our ability to control.

Spending and more spending. The gravest concerns revolve around government budget issues. States, cities and towns are struggling to rein in spending enough to remain within shrunken revenues. Such moves are necessary and appropriate but also can dampen the local affected economies. At the same time, most major trading nations are showing dangerous levels of government deficit spending. Greece has been the most acute example, having been bailed out by a consortium created by the European Union. Greece’s government deficit as a percent of GDP is over 13%. The U.K. and the U.S. are not too far behind with deficits as a percent of GDP of 11% or more. Here are the statistics for the Group of 7 economies.

Fiscal 2010 deficits as % of GDP
United Kingdom11.6
United States11.0

In the short run, the U.S. can get away with such massive deficit spending because net federal debt as a percent of GDP is the second lowest ratio among these nations at 66%, bettered only by Canada at a mere 32%. If the U.S. doesn’t tighten spending, however, debt to GdP will climb rapidly with unknown consequences.

Concern about longer-term structural deficits is sapping enthusiasm for continued stimulus. Meeting in Toronto in late June, the Group of 20 (G7 augmented by other important nations such as Brazil, Russia, India, China, Saudi Arabia, etc.) agreed to a goal of halving their deficits by 2013 even while accepting President Obama’s plea not to cut spending too quickly for fear that less stimulus would lead to renewed recession. by 2013 there will likely be some disparity among the twenty. Germany and the emerging nations are already on a path to reduce their relatively small deficits through spending discipline; the new U.K. government has put together a budget that will take them in that direction; and the U.S. hopes to halve the deficit by increasing revenues through economic growth and, presumably, through the expiration of the bush tax cuts. uncertainty about the methods and pace of deficit reduction is worrisome to investors, unsettling to markets.

A conundrum. In the face of these deficits, very low interest rates and inflation would seem improbable, but that is the current situation. Why?

Inflation is first a monetary phenomenon, arising when the money supply increases faster than actual production of goods and services. Thus one of the reasons inflation remains low is that the rate of increase in the money supply has been slowing over the past two years. There was a 6% increase in the second half of 2008. Since then the total increase has been less than 4%, and the increase over the past twelve months has been less than 2%.

Further, excess capacity abounds, inhibiting price increases and promoting discounts, as the recession and slow recovery reduced demand for all manner of goods and services. eventually, excess capacity will be absorbed. when that happens, we can only hope monetary authorities are vigilant to the risk of developing inflation.

Capitalism is in the doldrums. Low interest rates are symptomatic of slow economic growth. The Fed has succeeded in its goal of keeping interest rates low at least in part because both businesses and households have reduced borrowing and spending. The public’s outlays of money declined as the government’s demand increased. The table on page 3 shows borrowing trends for the public and the Federal government, a plausible proxy for trends in cash outlays. For more than a year both businesses and households in the U.S. have been reducing outstanding debt. Government has been the only borrower.

The private sector thus has money but a predilection to hoard it in the face of today’s uncertainty. There are huge cash positions that in more normal times would likely have been invested more productively, but today they rest in money market funds and bank deposits seeking safety.

Money market funds of all types collectively hold nearly $3 trillion, and time deposits at banks are nearly $7 trillion, $1 trillion more than three years ago. banks are awash in deposits, but loan demand is sluggish. All this money must be invested somewhere – in Treasury bills, short term government agency issues, commercial paper, etc. And then there is China. U.S. dollar holdings in China grow every day, and those dollars also must be invested somewhere. The U.S. Treasury is the primary beneficiary. At least all these sources of funds provide the money to fund the Federal deficit at unusually low cost, modestly lessening its impact for the time being.

But the accompanying sluggish growth causes unemployment to remain high, slows sales growth in most industries, and threatens consumer confidence.


A series of unfortunate events. Over the post-WWII period there have been other episodes in the U.S. economy and markets severe enough to leave investors badly shaken. In the 1970s it was the second Arab-Israeli war and the Arab oil embargo that followed, lifting all commodity prices significantly and lighting the fires of inflation that burned hotly for nearly a decade. Late in the 1980s it was – guess what – overheated real estate markets in both residential and commercial properties fueled by aggressive lending. The Federal government initially made things worse by tightening capital rules for savings and loans at just the wrong time, but they did then fix their problem nicely with the resolution trust Company that took over bad loans from failed banks. These situations were very different, but they have one thing in common. They ended, and normalcy returned.

When we are in the midst of such crises, it seems impossible to find the way out, but in the two examples cited above the Federal government did ultimately find proper courses that helped the economy get back on the right path. This time, markets are being roiled by doubt over whether governments here and abroad are following the right course.

Can stock markets learn to live with today’s level of uncertainty? Imagine for a minute that we are wearing blinders that hide government deficits, troubled European countries, the oil spill – all the things that are weighing heavily on the world. we can see only stock market fundamentals, neatly summarized in this graph:


Even in the middle of 2009, corporate managements were forecasting very strong earnings gains for 2010. So far this year, reported earnings have been showing even greater than expected improvement driven primarily by productivity gains. businesses began cutting costs – including laying off people – at the first whiff of recession, and inventories were kept low through the recession. Thus companies were lean and ready to profit handsomely when sales picked up even a little. earnings estimates for this year have been increasing, and estimates for 2011 are strongly higher again. with interest rates and inflation very low, stocks would certainly be responding to the upward pressure of earnings if not for concerns about government deficit spending and slow economic growth.

In our valuation model, where the key variables are earnings growth and interest rates, the S&P 500 is priced scarcely more than half its valuation. In any other world situation this picture would present a major buying opportunity, and in the short run it probably does now as well.

Uncertainty is the enemy of markets as well as business investment and hiring. even though stock valuations are extremely low, there are ample reasons why stocks might very well remain priced below fair value for some time to come. Despite recent weakening of some economic data, continued economic growth -though modest by historical standards -is the most likely scenario. with such a price to value imbalance in the stock market, any morsel of better news could very well trigger a rally in stock prices.