Reviewing the recent news I can't help recalling a famous quotation from the early American patriot Thomas Paine:
These are the times that try men's souls.
That was the first sentence of Paine's pamphlet The Crisis, written in December of 1776, and reflecting the difficult and uncertain circumstances at the beginning of our nation's war for independence.
Of course, were Paine alive and writing today, 235 years later, he would no doubt feel constrained to include the souls of women in his statement...but his statement would still be a fitting commentary on our own difficult and uncertain situation at the moment concerning our markets, our economy and our government and politics.
We were not surprised to see how stocks sold off sharply last week following the completion of a debt ceiling agreement in Washington. The 11th hour agreement, which occurred in the context of deteriorating economic data, has the net effect of imposing austerity at a time when stimulus (of the variety that leads to job creation) is needed.
Again not surprisingly, selling has continued this week, aided by Standard & Poor's rating downgrade of U.S. government debt over the weekend. The move by S&P wasn't entirely unexpected and is largely a symbolic move, perhaps motivated by the company's desire not to miss the boat on one crisis after missing the 2008 financial crisis by such a wide margin.
And while the news rocked the stock market, it's worth pointing out that U.S. Treasurys remain a top choice for investors seeking a safe haven. Prices continue to move higher - signaling that the market still views them as safer than other choices. The 10-year Treasury, important in that many other lending rates key off it, currently yields just 2.4 percent. Two-year Treasurys are being sold at a yield of just 0.24 percent, reflecting extreme pessimism among investors.
"Debt Crisis" is not a term applicable to only the domestic scene, of course. Markets in the U.S. have also responded adversely to the on-going financial crisis in the EU, where investors have turned their focus to Italy and Spain. This fear of contagion has forced the European Central Bank to buy bonds of those countries to push down borrowing costs and attempt to restore calm to the market. As we've discussed in the past, the way it is structured now, the euro currency union is ultimately destined to fail. But in the short run at least, Europe's woes are a problem that can be fixed by throwing sufficient funds into the mix.
Returning to our equity market, remember that sharp declines like we've experienced in the last few weeks tend to be bullish six to 12 months out. However, it's not clear at present if we're at a bottom just yet, although we're likely to be close.
The big question among investors now is whether we're experiencing a repeat of 2008 or 2010. Of course time will tell, but most likely it will play out much like 2010. For starters, the economy is far less leveraged today than it was in 2008 and the Federal Reserve has since demonstrated a willingness to step in with unprecedented amounts of liquidity to combat the situation.
You'll recall a year ago, as the dollar and stocks were under pressure, threatening to derail the recovery, bonds (and gold) meanwhile were rallying. Ben Bernanke announced QE II at an annual gathering in Jackson Hole, WY sponsored by the Kansas City Fed, and that turned the market around.
Fast forward to today: the economy is slowing, stocks are again down by comparable percentage and bond yields are once again scraping along at their lows. Given the deeply bitter feelings exhibited during the debt ceiling debate, Congress is in no way inclined right now to step up with a stimulus package. That leaves the Fed with little choice but to come forward with another round of money printing. If the market remains under pressure this could happen as soon as this week at the Fed's regularly scheduled policy-setting meeting.
Keep in mind that from an economic perspective, commodities - and oil in particular -have come down with stocks in anticipation of a slowdown (and possible recession). We haven't seen much benefit at the pump just yet, but we will in the next couple of weeks. Lower oil prices (and commodities in general) will ease pressures on consumers and businesses alike.
Perhaps the most surprising aspect of the fall - at least so far - is that commodities (the actual materials not the stocks) have held up considerably better than the stocks. Virtually every commodity and broad based commodity index is about 10 to 20 percent above its 52-week low. By comparison, the S&P closed today just 5 percent above its one-year low. What this tells us is that the weakness is much more concentrated in the developed world and - unlike 2008 - does not reflect fears that the entire world is going to spiral down.
While this is not a time to go out on a limb, rapid growth in substantial economies suggests that the U.S. economy could benefit from this growth. The developing economies (as long as they are not profoundly affected by the U.S. and Europe) are not headed for dire straits.
Thus, while it may sound contradictory, commodities are a twofold plus. First, the price weakness represents an implicit tax cut. Moreover, the fact that they have not been catastrophically weak suggests worldwide growth is still on a decent trajectory.
More money from the Fed, lower implicit taxes, growth in developing economies, exceedingly low interest rates, and valuations on major averages that are approaching generation lows all point to the potential of a major rally.
Still it never pays to be a hero. The tinder is drying but we probably still need some sort of match. That match could be an announcement by the Fed or something out of the blue, but it is not something you can predict. While waiting for the next up-leg we are going to repeat the advice we have been giving ad nauseam. The best shelters in the storm are gold and gold-related investments. Incidentally, with gold at $1700 and the S&P at 1100, gold has outperformed the S&P - dividends included - for 40 years. And for any of you who think gold is in some sort of bubble name me one CFA or CFP who would rank gold as an asset class. That is a rhetorical question, of course.
So "if you can keep your head when all about you are losing theirs..." (to quote Kipling this time), you stand a good chance to weathering the economic and political storms we're going through right now.
Sincerely,
Dr.Stephen
