18th-century financier Baron Rothschild famously quipped, “Buy when there’s blood in the streets, even if the blood is your own.” Well, there’s plenty of blood in the streets (mine included), and the question for investors is whether they should buy, sell, or hold. Before we answer that question, let’s review the events that preceded the recent market downturn, including today’s 512-point drop in the Dow.
After weeks of truly first-rate political theater, Washington finally got a debt deal done (the Budget Control Act, or BCA), averting a downgrade of US government debt. In the process, we saw our esteemed leaders do what they do best—try to get themselves re-elected and kick the can down the road. Because most of the austerity measures are spread over the next ten years, we don’t think the spending cuts outlined in the BCA will push the economy into a recession (as our own Dr. Brian Jacobsen noted on Tuesday). However, there were no pro-growth measures attached to the act. And while most investors and media-types were focusing on the telenovela unfolding in Washington, we also saw some very weak economic data released. These data included: low second quarter real gross domestic product (GDP) growth of 1.3% (quarter over quarter, annualized), first-quarter GDP growth revised down to an anemic 0.4% (from a previously estimated 1.9%), and stubbornly high initial jobless claims numbers. Across the pond, Italian and Spanish governments have passed pre-emptive austerity measures, yet their sovereign debt spreads (versus German Bunds) have spiked by about 150 and 100 basis points, respectively—the bond markets are clearly not convinced. And equity investors across the globe began selling their shares.
So, let’s get back to the question of whether we think investors should buy, sell, or hold. Aside from the astute observation that equity shares are now cheaper, there are several reasons we are constructive on the equity markets, especially at these levels. First of all, earnings remain strong. Of the 58% of the companies in the S&P 500 that have reported earnings so far, 79% of them beat analysts’ expectations. We think estimates will come down as analysts revise their expectations for lower GDP growth, but we don’t think we see a recession this year, and we could continue to see double-digit earnings growth, as margins stay at historically high levels. Secondly, market valuations are reasonable, especially at these levels, and especially when you compare them against fixed income assets. Lastly, the liquidity remains very supportive of risk assets. Because of tight lending standards and low demand for loans, money growth has not found its way into the real economy. That money finds its way into the financial markets, lowering yields and supporting risk assets like equities.
Our biggest concern is market sentiment. The technical picture, so strong just a month ago, has clearly weakened. Several trend measures have weakened, key support levels (1250 and 1230 on the S&P) have been breached, and market internals are under pressure. When we review the pros and cons for the stock market, we come back to our economic forecast of slow but positive GDP growth, which we have maintained throughout the year. Assuming companies can maintain high margins (enabled by the dismal labor situation), high-quality companies should be able to generate reasonable earnings over the next several quarters. We view this market pull back as a potential opportunity for investors to (finally) rebalance their portfolios to their strategic target weights. We may see further declines, market volatility will likely remain high, and there could more panic selling like we saw today, but in our view the fundamental picture is sound.