Most of us look forward to August as a month for relaxing in the summer weather, maybe taking a holiday, or at least leaving some of our day-to-day cares behind for a while. Not this month, at least not for those of us involved in the capital markets. August was a crazy month. As the chart below shows, the volatility in the equity markets was more than twice the average of the last two years. The Dow Jones Industrial Average closed more than 1,000 points above its low for the month, but was still down 530 points or 4.3% for the month.
The cause for most of the craziness was of course the utterly inexplicable and totally irresponsible behavior of the United States Congress. The Republican Party chose to play chicken with the Democrats and threatened, until the very last minute, to refuse to extend the authority of the federal government to borrow money. Had the US in fact defaulted on its debts the consequences would have been severe. By August 9th the DJIA had fallen 16.8% or more than 2,000 points from the high point in July only seventeen days earlier. There were four trading days in August with declines of more than 400 points, and five days with gains of more than 250 points.
We are so closely tied to the US economy that our stock market inevitably reflects what is going on south of the border. The TSX index looked just like the DJIA, falling by 1,900 points in the same seventeen day period, and then recovering by 1,150 points from the low for the month. When the smoke cleared, the TSX was down a very modest 1.37% for the month.
It is hardly surprising that the volatility led to a lot of frayed nerves. We spoke to many clients who were worried that we would see a reprise of the market bloodbath of 2008. Catastrophic headlines in the media led many investors to worry about default on European sovereign debt, collapse of European banks, and a “double dip” recession in North America. While some of these fears were well grounded in fact, most were driven by emotion.
Our job is to view the markets dispassionately, to separate reason from fear, and to draw conclusions as to how we should invest our clients’ funds. Here is how we see the economic situation at present, and how we intend to proceed in the near term.
- We don’t think there will be a recession in the United States. The US economy continues to suffer from high unemployment and lack of demand for housing. Neither of these problems will be cured in the short run, although we are somewhat heartened by signs of stabilization in the prices for new and existing homes, and by some growth in employment. None the less, while growth will be meager and below normal levels, there is little to suggest another recession is on the horizon.
- Fears of sovereign debt default in the Euro zone are overblown. Greece and Portugal, both small economies, are in serious trouble, and may well default on their debt. However there is little chance that a major country such as Spain or Italy will cease to pay its creditors on schedule.
- Euro banks are wobbly but not unsafe. Many have loans to Greece and Portugal which will have to be written off, but most of the banks have balance sheets which are able to withstand these credit losses. The European Central Bank has demonstrated that it will intervene in the market if necessary to provide capital to weaker banks. The rate at which banks lend money to each other, the LIBOR, is currently at 0.33% for 90 days, exactly where it was six months ago. In the darkest days of the banking crisis in 2008, it spiked to over 4.25%. Until we see signs that banks are unwilling to lend short term money to their peers, we will remain confident in the health of the system.
- Corporate earnings support higher stock prices. Earnings in the 2nd quarter in both Canada and the US were strong, in spite of the weak economies in both countries. Current estimates are that the S&P 500 is trading at about 12 times earnings for this year, and about 11 times estimated earnings for 2012. This is far below the long-term average multiple of 16 times earnings.
- Low interest rates will persist for at least two more years. This is now the declared policy of the Federal Reserve Bank in the US. It makes the prospect of inflation more remote, and raises the value of stable dividend paying stocks such as banks, utilities, telecoms and pipelines.
- Commodity prices will continue to be supported by strong demand from the growing Asian economies. We believe that the sell-off in energy and materials stocks which we have seen in the past few months is overdone and likely near or at an end.
In summary, we reject the apocalyptic scenarios which are currently making the rounds on the internet and in the press. Remembering always that investment is a marathon and not a sprint, we continue to believe that value investors can find good stocks to buy which will reward them both with dividends and capital appreciation over time.