In 1897, when false rumors of his death circulated, Mark Twain was quoted as saying “The reports of my death are greatly exaggerated.”

In a similar manner, recent media rumors of a double-dip recession have been significantly diminished as data released yesterday shows that the U.S. economy is not dead either with the 3^rd quarter experiencing the fastest quarterly growth in the past year and a big acceleration from the 1.3% pace from last quarter.  This is continued confirmation of encouraging reports during the month of October: strong 3^rd quarter corporate earnings and the S&P 500 up over 10% month-to-date.

As a client with investments in our Managed Accounts, we wanted to give you a quick overview on our positioning with the current market decline and volatility that has been present since the first of August. As you may have noticed, we have been rotating some of our sectors the past couple of months as sector leadership (on a relative basis) has shifted. You may have also noticed that we have not being fully invested at various times during the past couple of months in an effort to try and preserve principle throughout the volatility. Currently (as of 10/5/11), we continue to not be fully invested as we are being a little cautious until we see the market start to take a more definitive direction.

Since its initial drop the first week of August, the S&P 500 has been trading within about an 8% range…meaning it has been going through cycles of gaining 7-8% then quickly falling back down by the same amount. This creates a stock market that has no clear direction until this range-bound trading environment is broken. We do not try to predict which direction the market will head, but we are watching the market movements very closely and have determined what we consider to be the key entry or exit points based on our technical analysis. If we see a breakout to the upside of this current range, we will look to get back fully invested. However, if we see the market fall lower through this range, we will look to pull back more of our portfolio to cash or bonds in an effort to try and preserve principal until we see momentum shift back to a more positive investing environment.

2008 all over again?

The month of August has been an interesting time to be an investor. U.S. stock markets have had 6 days (as of Aug. 18^th) with moves of 4% or greater—both up and down, with some of these wild swings happening on consecutive days. What causes stock prices to drop 5% one day but then gain 5% the next? The quick answer is simply ‘fear’. Stock markets and investors are not always rational and this emotional response contributes to the violent swings of stock prices we’ve experienced this month.

Think about this: during the week of August 8^th, the S&P 500 either went up or down by 4% or more for four consecutive days causing massive panic and investor redemptions of their stock holdings. However, for the week, the S&P 500 was down less than 2%. Not a great week of returns, but certainly an overall return that we see often for a week’s time. The large movements from day to day made it feel far worse though.

For many, there are still lingering wounds from the drop in equity prices from 2008, causing jittery investors to fear the worst now that we are experiencing this current volatility. As an investor, the question we must ask ourselves then is “Are we looking at another 2008 crisis?” At this time, in our mind, the answer is no. In 2008, we were mostly suffering from a liquidity crisis—companies could not finance their operations as lending froze up. In 2011, the fear is more centered on future economic growth, not an economic collapse from companies not being able to fund current operations that was a fear in 2008.    

At this time, there are really two areas driving up the fear quotient in these markets: European debt problems and the concern of another U.S. recession. The concerns over Europe’s debt troubles are certainly justified, but they are not new or unknown. This has been going on for over a year now and the European monetary authorities have the resources and tools to deal with their problems; however, stock markets have days when they aren’t confident in the decisions being made by leadership in Europe, thus creating market volatility. Secondly, recent reports on the U.S. economy are showing mixed signals for economic growth. There is no doubt our economy is in a fragile state with unemployment levels still high and the housing market still struggling. Despite this, corporate profits have continued to rebound strongly despite this slowed momentum, with S&P 500 operating earnings hitting an all-time high in the 2^nd quarter of 2011 (in 2008 corporate profits were declining, so this is another major difference between now and then). Corporations have already ‘trimmed the fat’ from the downturn in 2008 are in much better shape to handle a continued difficult economic environment. 

The danger with our current environment is two-fold. One is that the European debt problems escalate and get too far out of hand causing further distress and panic. The second revolves around our confidence here in the United States. Tracking polls are already showing a decline in consumer confidence from all that has been going on. A concern is that consumers, investors and particularly employers act based on the memory of 2008 and hunker down for a new recession. There is a real danger we could scare ourselves into a recession by cutting back because of ‘what could happen’.

With all this being said, if we look at the earnings yield on stocks (which is just the inverse of the price-to-earnings ratio) and the yield on U.S. Treasury bonds, stocks are now cheaper relative to bonds than they have been at any time over the past 30 years. Also, with this recent decline in stock prices, the S&P 500 is now trading at around 10.5 times the earnings expected over the next year—well below the 16.4x forward P/E ratio the S&P 500 has seen on average over the last decade. This extreme in relative valuations suggests that markets have already priced in a very ugly outlook for the economy.

So, are we looking at another 2008 market environment? At this time, the data is certainly not indicating that. We believe it is more of a ‘two steps forward, one step back’ recovery accompanied with slow growth as we continue to move ahead. These last few weeks are certainly in the ‘one step back’ camp but there are still pockets of good economic data, despite the headlines. Whatever happens, we will continue to monitor the economic conditions closely and keep you informed.

It is natural to be concerned about what is currently going on with the markets over the past week. However, in times such as this, it is important to not become an emotional investor that leads to quick, irrational investment decisions. As of this writing (Aug. 3^rd), we aren’t even experiencing the worst pullback since the initial market rally in 2009. You may not remember, but last April things looked pretty sour as well. Europe’s problems were surfacing and the US economy was showing some signs of slowing down. In April 2010 the S&P 500 peaked at 1,217 and dropped down to 1,022 during the first of July 2010—a drop of 16% (at that point, the S&P 500 was also down on a year-to-date basis by 8.5%). If we compare that to now, the S&P 500 is down about 10% from its high in April 2011 and down only about 3% year-to-date. So, while the last week has seemed like a quick decline, the reality is that we experienced a similar situation in 2010—as you may recall, in 2010, the S&P 500 eventually ended up by over 14%!

Another thing to remember is that, on average, the stock market drops at least 10% at some point in time every year. That type of drop is a normal (and necessary) type of movement in a healthy market environment as stocks never go up in a straight line. However, this type of volatility is what keeps some investors from being successful over the long haul as they panic during short term declines. We know that markets can move very quickly, so it is important to not panic. I’m sure many of you know people who got out of the markets during the decline of 2010 and then missed the subsequent gains the last twelve months have brought.

You may be thinking “Here we go again…” or “Not another 2008 experience”. However, in our opinion, there are differences between our current environment and what happened in 2008. This current decline is not being caused by a large ‘bubble’ as it was in 2008. Corporations and their profits have been doing very well. In fact, corporate earnings are at their all-time high levels and most corporations have very healthy balance sheets. For example, Apple, has more than $76 billion in cash and there are many companies in similar strong financial situations as them. Based on good (and estimated rising) corporate earnings, stocks are currently selling at very reasonable prices, relative to those earnings.

We are not discounting that there are a lot of concerns and potential headwinds for our economy and the stock markets. However, sometimes the positive data that is happening gets lost by the media and in our conversations. There is sure to be continued volatility with stock prices—just as there always is. What we encourage you to do is remember the financial goals you have. We want to be mindful of our current surroundings but focused on the big picture and not make any knee-jerk reactions. However, we will continue to be closely watching as this unfolds and should the headwinds become stronger we will take appropriate actions to keep you informed.