A month ago stocks were trading near recent highs on improving corporate earnings and a steadily improving US economic backdrop. Investors were not euphoric but a certain amount of complacency had crept into the market with the volatility index at levels that indicated little in the way of demand for downside protection. Individual investors were not sold on recovery though, still regularly pulling money out of US stock funds while funneling increasing amounts to foreign stock funds and especially bonds. Individuals seemed unimpressed with the recovery in corporate profits, companies’ lean balance sheets and all manner of improving economic statistics. Their actions did conflict somewhat with the results of various sentiment polls which showed rising bullishness but bears were not exactly missing during the rally with many a pixel devoted to the case. So the market rally of nearly 80% was impressive but it wasn’t exactly irrational exuberance over on Wall Street.
Now, corporate earnings and the steadily improving US economic backdrop are in question. The demand for puts and downside market protection has driven the volatility index to levels it has only seen a few times in history. Individual investors continue to pull money out of US stock funds and now they’ve started to yank it from foreign funds as well. Even bonds aren’t seeing the inflows they have over the last year with the exception of muni bond funds which are seeing impressive inflows. The asset of choice is cash in some form which is almost guaranteed to lose you money in real terms after taxes and inflation are taken into account. Investors would seem to prefer a sure real loss to even the potential for a real one in the stock or bond markets. I must admit that during the recent “flash crash” as it has now been named, the comfort of a small real loss in money market was surely preferable to the snarled gut feeling that accompanies a market in free fall for no apparent reason.
One does wonder though if things have really changed all that much in one short month. Were the growth prospects of Europe really all that much better a month ago when Greece, Spain, Portugal, et.al. had roughly the same amount of debt they have today? Oh, wait, I guess the fear is that these countries and some others in the EU have recently announced that they are adopting “austerity” measures that amount to little more than a complete misunderstanding of that term. The fear as expressed in a recent WSJ headline is that these countries are adopting “Hooverite” policies which will lead to further economic weakness and more austerity measures down the road which leads to further economic weakness until the entire Mediterranean economy consists of a giro stand and an overrated film festival. Of course that ignores the fact that Hoover never pushed the austerity solution; it was his predecessors who would have advocated such an approach. But hey it isn’t my job to rehabilitate Hoover’s reputation so call it what you will but please spare the noun austerity further embarrassment.
I don’t think investors are reacting so much to the “austerity” measures as they are to a lack of any growth oriented policies. Austerity alone – even real austerity rather than the fake variety currently on tap – cannot solve the debt problems of Greece or Spain or Europe or the US for that matter. Greece ranks 109th out of 183 countries ranked by the World Bank for ease of doing business, 140th in ease of starting a business and 154th in investor protection. Those are not confidence inspiring numbers and seem unlikely to attract the capital Greece will need to grow out of the hole they’ve dug. Spain, by the way, doesn’t come out much better at 62nd, 146th and 93rd respectively. These rankings don’t tell the whole story – Portugal ranks ahead of Chile in ease of doing business for instance – but they do show that there is plenty of room for meaningful improvement that would have a positive impact on the economy. And frankly without some kind of supply side response, there is no chance that these countries will grow enough to even maintain their debt at current levels much less reduce it to more reasonable levels. Fitch downgraded Spain’s debt to AA+ last week because “the process of adjustment to a lower level of…indebtedness will materially reduce the rate of growth”. That doesn’t have to be true unless Spain ignores all the other problems with their economy to focus exclusively on debt reduction through higher taxes and lower spending.
The problems of the world economy have not changed enough in the last month to warrant the beating that markets took last month. Europe needs to restructure their economies, but the politicians actually seem to be getting the message. If they don’t, I’m sure voters will send it loud and clear when they get the chance. Asia may be slowing a bit as China tries to prevent inflation from getting out of hand, but I don’t see anything yet from outside that supports the view of a double dip recession in the US. If our economy does slow or fall back into recession I think we will be able to point to our own policies as the culprit; finding a foreign scapegoat won’t be necessary. There are surely some uncertainties to get over in the next few months in the US economy. Among other things, the home buyer’s tax credit is ending and so the housing market faces a critical test in the next few months. We also have the reality of spending cuts at the state and local level that will be required to balance budgets. Those cuts will be painful for the ones who have to bear them, but I don’t believe that they will be so severe that they will push the economy back into recession.
For now, I see no reason to believe that the US economy is about to fall back into recession, but changes do need to be made. Like Europe we face our own debt problems that cannot be solved through more taxing and spending. Yes, we need to cut spending but just as important we need to adopt pro growth policies now before the market forces the issue as it has in Europe. There are any number of policies that would positively impact growth but generally it means reducing taxes on capital and wages while raising them on consumption. We should be able to raise growth and reduce our debt at the same time; we have the opportunity to do it now when it isn’t urgent or we can do it under duress as the Europeans are being forced to do.
I am still concerned about the markets because of the uncertainties outlined above but with sentiment having changed so quickly I’m a lot more comfortable now than I was a few weeks ago. The impression I get from talking to individual investors is that they are worried not just about a correction but another crash. I believe that to be an overreaction based on the fundamentals. Stocks are not expensive (although that is a bit different than saying they are cheap) and the economy shows no significant new difficulties at present. If other investors are expecting something that is statistically unlikely – and another crash right now would certainly qualify – I can’t help but take the other side of that trade. Warren Buffet says that we should be greedy when everyone else is fearful. That would seem to describe the current environment pretty well.
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By the way, I’ll be visiting the northeast from June 2nd to June 9th. I’ll be staying in Hampton, NH but taking day trips around the area. If you are in the MA, NH or ME area and would like to meet up, let me know. I’m always open to meeting new people and discussing markets, economies and politics.