Saturday, August 6, 2011

Stock Market Sell-Off

From the Desk of Joe Rollins

When investing assets on behalf of our clients, I aim to evaluate the facts and disregard emotions in my decision-making process. In doing so, I spend an enormous amount of time researching various subjects that effect the marketplace. In the end, market performance is represented by correct valuations and not by daily emotions. I can’t help but think that Thursday’s massive sell-off of over 500 points was driven by emotions instead of clear thinking.

As I mentioned in yesterday’s post, the sell-off basically occurred when the European Union bucked Italy and Spain by refusing to help them out of their financial malaise. You may recall that when Greece, Portugal and Ireland fell into financial despair, the EU offered to bail out each of those countries if they cleaned up their mounting sovereign debt woes. Of course, the bailout process for these countries is ongoing: the EU finalized another bailout package for Greece last month; Ireland’s debt was downgraded to junk by Moody’s on July 12th, and; Moody’s, citing concerns of a second bailout, also downgraded Portugal to junk status last month.

On the other hand, Italy and Spain, with the Eurozone’s third- and fourth-largest economies, respectively, are too costly for Europe’s bailout fund. Even though the sovereign debt of each of these countries is moving higher exponentially, they have so far managed to avoid the kind of aid given to Greece, Ireland and Portugal. Basically, all of the Eurozone banks are holding the sovereign debt of their fellow European countries. While the banks appear to be solvent on paper, if the debt was discounted to an appropriate level, all of the major European banks would be essentially insolvent.

The theory regarding Thursday’s sell-off is that if all of Europe’s banks can’t afford to lend to businesses, then the Eurozone countries would fall into a recession. Of course, the U.S. might also be impacted due to its financial institutions’ considerable holding of European financial assets. Exports to Europe from the U.S. and Asia would also be impacted due to Europe’s reduced borrowing capacity and spending cuts. Therefore, the true catalyst for the major sell-off had less to do with the U.S. economy and more to do with the ongoing European debt crisis.

Thursday’s trading day brought continuing reports of the plight of the U.S. economy. I reiterate that while the U.S. economy certainly isn’t robust, it is nowhere near recession territory. While we undoubtedly suffered through a financial crisis during 2008 and 2009, we are still on the long road to recovery. Moreover, Europe was never as far down from a recession standpoint as the U.S., and they’ve not fully recovered, either.

It’s true that the GDP for the first quarter of 2011 was revised down to a miniscule 0.4%. Furthermore, growth in GDP for the second quarter of 2011 rose at a 1.3% rate. Undeniably, this isn’t very high, but it’s still positive. Regardless of the commentary, the U.S. GDP has been continuously positive since the second quarter of 2009 through the current date.

Until recently, nearly all of the major economists, including those with the Federal Reserve, were forecasting GDP growth in the second half of 2011 at 3%. Within the past few days, however, many of those same economists have lowered their predictions to 1.5%. While the predicted lower growth is disappointing, it’s still not negative.

It was announced yesterday morning by the Department of Labor that payroll employment rose 117,000 in July. More importantly, the U.S. private sector jobs increased by 154,000 during July, which was nearly double the projections that were being reported before the numbers were released. Furthermore, the change in total non-farm payroll employment for May was revised from 25,000 to 53,000, and the change for June was revised from 18,000 to 46,000. Even with the unemployment rate changing little in July (a dismal 9.1%), it is still clear that the economy is trending up and not down. If the GDP were 0.4% for the first quarter, 1.3% for the second quarter, and winds up being 1.5% for the second half of 2011, those are upward – not downward – moves by anyone’s definition.

A contributing factor in Thursday’s sell-off and the high volatility in yesterday’s market performance is the “high frequency” trading effect on the market. Basically, this is where computers trade with high frequency when certain market events occur. By far, most of the volume each day on the markets comes from these types of trades. No human is involved, and the computer reacts to events, not reality. On Thursday, the S&P index broke its 200-day moving average, creating a massive sell order from the high frequency traders. The enormous sell-off towards the end of the day was undoubtedly attributable to computers thinking they know more than individuals. Maybe they do, but I doubt it.

As I’ve stated in prior posts, stock market valuation consists of three major components:

  • Interest rates impact stock market valuation since alternatives for money compete with interest rates and stock prices. Today, the 10-year Treasury is selling for a miniscule 2.5%, which is practically an all-time low. There are several stocks that can be bought with dividend rates in excess of 5% that constitute a much better value than the 10-year Treasury bond. Isn’t it ironic that during the first part of this week, investors were concerning themselves with a potential default on U.S. Treasury bonds while the last part of the week, they were stunned by the 10-year Treasury winding up at nearly its lowest yield ever. This is just another inconsistency to confuse the issue.

  • Earnings continue to be extraordinary. With earnings projected to be over $100 per share for 2012, unprecedented records will be set. It’s unlikely for the U.S. to fall into a recession with the current strong earnings and the forecasted earnings for 2012 being even stronger. With close to $2 trillion in cash currently held by U.S. corporations, there’s rarely been another time in our financial history that U.S. corporations were so well-prepared for the future.

  • Public sentiment is unquestionably waning at this time. With Washington’s failure to accomplish anything worthwhile, many consumers are sitting on their hands while many investors with cash to invest are unwilling to do so. It’s certainly a time where the public’s negative emotions are impacting stock market valuation. What other explanations can there be for the never-ending gold commercials? Gold investments are made for emotional – not financial – reasons. It offers no dividends, has a lack of marketability, and isn’t even scarce. Yet given the negative attitude of investors, gold has hit record high prices. Not much can be done to improve public confidence until Washington leadership improves.

  • Those of you who were readers of my quarterly newsletter, The Rollins Report, may recall an edition published in 2003 in which I explained how former Federal Reserve Chairman Dr. Alan Greenspan calculated the fair value of the S&P 500. Compared to today’s economy, the economy was more normal in those days. At that time, the projected earnings for the S&P 500 was $61.83. Also at that time, the 10-year Treasury rate was 4.07%. To get the fair value of the S&P 500, you divided the projected earnings by the 10-year Treasury rate, which provided a result at that time of 1,519. At the time the newsletter was published, the current value of the S&P 500 was 1,142, which indicated a significant undervaluation of 33%. Was that calculation accurate? The S&P 500 for 2003 made a total return of 28.7%.

    To illustrate how crazy the numbers are today – with earnings so high and interest rates so low – the same calculation would play out as follows: Estimated earnings today are at $100 and the 10-year Treasury is at 2.5% today. This provides a fair value of the S&P 500 of 4,000. This represents a 340% increase which, of course, would be irrational.

    Part of the problem with the calculation today is that interest rates are much too low from market prices. If you used a more normal interest rate of 4%, the S&P 500 would still have a fair value of 2,500 – basically double what it is today. Given that interest bearing accounts are essentially earning zero, there are a wealth of stable dividend stocks paying 5% and higher and any standard valuation of the stock market is cheap, I can see no real economic reasons for yesterday’s sell-off.

    Therefore, the conclusion should be drawn that yesterday’s sell-off was unwarranted. However, it can’t be denied that it actually happened. Our loss in wealth yesterday was real, not perceived. It happened even though it shouldn’t have.

    It’s difficult to invest from an emotional standpoint, for emotions run hot and cold based upon what the media reports each day. By any standard definition, the stock market is cheap and alternative investments are lacking. While losses like what we endured yesterday certainly hurt, the best course of action is to continue to stay invested for the long-term.

    Again, while it’s true that the U.S. economy is weak and has suffered a short-term soft spot, there’s no evidence of another downward spiral. Stay tuned!

    As always, the foregoing are my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

    Best regards,
    Joe Rollins

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