Last December, at a small pre-Christmas luncheon, I was asked by the host to look ahead to 2011 and offer a few thoughts regarding the economy and the financial markets. To summarize briefly, I opined that the US economy was gradually recovering from the “great recession,” that major corporations, having cut costs sharply, were benefitting greatly from an improvement at home and particularly from rising demand out of the emerging economies, and that corporate profit growth this year would greatly outpace GDP growth. On that basis, US equities, which were then selling at about 13x projected 2011 profits were quite attractive, particularly since most fixed income alternatives offered only meager yields, which seemed poised to rise as the economy recovered. Moreover, there was a “mountain” of sideline cash, and if only a small portion moved into equities that could support a strong rally.
With regard to the US I got most of it right, but it was all the macro issues I missed that have prevented any rally in stock prices this year and put what could be a long term lid on equity valuations, i.e. P/E multiples. The earthquake and tsunami in Japan, which disrupted the global supply chain, the sharper than expected cutbacks in state and local spending, the severe winter weather including floods, were minor impediments as it turned out relative to three other factors that I missed.
First, I failed to recognize the overwhelmingly anti-business attitude and policy making of the Obama Administration and a multitude of Federal agencies. I failed to see just how great would be the uncertainty and fear resulting from a wave of anti-business regulation and legislation, including both Dodd-Frank and Obamacare, all of which have caused banks to curtail lending, businesses to hold back on both hiring and capital expenditures and to maintain tight control over inventories. The hiring freeze, in turn, has greatly impacted consumer confidence, income growth and spending (the current Christmas surge notwithstanding). This has kept a ceiling on economic growth and is sustaining a high rate of unemployment.
Second, the ugly and unproductive partisan dispute over raising the Federal debt ceiling shocked both household and business confidence in the third quarter, and the fall out has only begun to subside in the last couple of months. Gridlock was once viewed positively as a means of controlling overspending and overregulation, but with both parties in the grip of their extreme wings there is no hope of any compromises to deal with the nation’s major problems. Contrary to conventional wisdom, I do not believe this gridlock will end after next year’s elections since twenty plus years of gerrymandering has created “safe seats” only for the extreme members of each political party.
But the most critical oversight on my part was my failure to gauge the utter incompetence of Europe’s politicians and bureaucrats, as they continually fall behind the curve in dealing with their sovereign debt, and the now widespread banking crisis that has thrown Europe into a recession and is causing a global slowdown that threatens the US economy and those of the major emerging countries, particularly China, India and Brazil. These Socialist politicians are simply ignorant of the power of market forces. The whole 20th century economic history of Europe has been one of protectionism, but in a globalized world with freedom of capital movement there is no hiding from financial market forces. The obstinance of the politicians has caused the markets to revolt, and the crisis will only get worse next year as Governments and banks must raise huge sums of new financing. Not only will a European recession impact the global economy, but if a few major banks there go bust, there would be great risk to our banking system from the opaque derivatives commitments. Frankly, I never imagined that our market would be held hostage to the daily news flow out of Europe, and so far at least, I see no solution to their problems.
Against this litany of macro issues which I failed to foresee has been the ever increasing impact of a few computer driven, high frequency traders, whose activities coupled with the lack of an uptick rule have created an intraday volatility that dwarfs anything in the history of the US equity market and goes virtually unrecognized by the regulatory authorities in Washington. A handful of traders are raking in billions at the expense of ordinary investors. The resulting intraday volatility has caused many investors to abandon equities altogether.
Both institutional and household investors have walked away from the equity market, in many cases never to return. As a result, the valuation of equities continues to be mired far below the average level of the last hundred years. I believe the US will avoid a recession next year, even as the European crisis drags down the entire “old world.” A global monetary easing cycle is underway which will support many economies and financial markets. The Fed will engage in QE3 if needed. Corporate profits will be retarded somewhat since Europe accounts for 20% of our exports, plus local production by US multinationals, and it will take some time for the emerging economies to reaccelerate. But the valuation of US equities is likely to continue to suffer from all these macro issues for some time to come. A modest gain in stock prices is good bet for 2012, but the full potential appreciation of equity values is some time off. Accordingly, going forward, our equity portfolios will emphasize, much more than we have in the past, the shares of companies with long records of annual dividend increases. Many of these outperformed in 2011 but still remain reasonably valued based on visible prospects for the years ahead. If, and when, the European crisis abates and global growth accelerates, we will move back toward economy sensitive issues.
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