September 19th, 2011
“It seems like the unremitting barrage of bearish news, which assaults us daily, will not end until the last worker is unemployed, the last dollar of profits has evaporated, and we have all consigned our future to our Government leaders in the vain expectation that they can “do something.” The media black-beat of lay-offs, write-offs, bankruptcies and failed expectations wears cumulatively at our collective psychology until we risk becoming convinced that there is no basis for hopes of recovery, that we perceive only risk where there is opportunity, and where the siren call of despair beckons us to capitulate. It is at such times as these that we must remember that in the recessionary environments of recent history of 1958, 1962, 1970, 1974, and 1982 a similar psychology prevailed, and yet in each instance the economy again recovered and led to very attractive periods of earnings and stock growth. It is the nature of investing that adversity creates the true bargains which provide the basis for future returns.”
These observations were not made today, but rather were found in Coleford’s Quarterly Comment on December 31, 1991. While much has changed in 20 years, the parallels to our current situation are remarkable and underscore the cyclical nature of the investment environment. As in the 1991 recession, the US and Europe economies are currently working through a period of painful adjustment that should leave them better positioned to participate in the long-sought-after recovery phase. While no one is forecasting a post 1991 recovery (the Canadian stock market peaked in 2000 after increasing in value by approximately 5 times and the US market increased by approximately 4 times over the period), history does have a habit of repeating itself and the doomsayers would do well to remember the lessons of the past.
Now, to the current situation: Global capital markets were under pressure in the third quarter due to slowing economic growth. GDP forecasts have been reduced to an average of 1.5%-2.0% in the US for 2012 and to 0.75%-1.0% in the Eurozone next year (as reported by Bank of America/Merrill Lynch) – both below normal recovery levels. Investor psychology and consumer sentiment are clearly negative as we digest daily helpings of negative economic news.
Much of this news is fueled by the American public and its growing frustration with the perceived inability of government to proactively address and resolve key economic issues, namely, the fiscal deficit and historically high government debt levels. This negative sentiment is plotted in the graph below.
These perceptions only grew stronger leading up to August 6, 2011 – the date the US suffered its first debt downgrade in 70 years. While this was a negative development, it provided a clear message to US leaders to reduce debt, and if ultimately heeded, could be viewed as a positive turning point.
The Eurozone also continued to struggle as Greece, Italy, Portugal and Spain grappled with high debt levels and eroding confidence in capital markets. As the strongest member of the region, Germany has agreed to provide bailout assistance in an effort to stem economic failures and stabilize the Eurozone in which it has significant economic interests.
Despite near term headwinds, global capital has been flowing into the US as evidenced by recent strength in the US dollar. This further supports our view that valuations, particularly in the US, are attractive and offer good opportunities for long term capital appreciation.
The sliver lining
Growth in emerging markets is forecast to remain strong in the range of 5.0%-6.5% in 2012. According to Bank of America/ Merrill Lynch, this translates into an expected global economic growth rate of 4.0%-4.5% next year.
Back to the future?
Given the barrage of negative news, it’s only natural that comparisons will be drawn to the 2008–2009 market crisis. Are we going there again? Certain underlying data suggest not:
- The TED (Treasury /Eurodollar) spread reflects the gap between US government three-month Treasury bills and the three-month London Interbank offered rate (LIBOR) – the global benchmark for short-term lending rates among banks. An elevated TED spread indicates there is a higher perceived risk of lending within the banking system. The current TED spread of 35-40 is down from mid-2010 highs of 46.71, and well below the extreme level of over 450 during the 2008/2009 financial crisis.
- Another important market stress indicator is the Volatility Index (VIX) which measures the expected volatility in the US stock market over the next 30 days, based on S&P 500 option trading. The VIX surged to nearly 50 in August but has since pulled back to approximately 40. This is still considered historically high but well below 2008/2009 levels of 80 and above.
- The Federal Reserve Bank of St. Louis created an index using 18 components, including the TED and VIX measures, to track changes in the overall stress levels in financial markets in a timely manner. The index has moved markedly higher since July to approximately 1.0, approaching a two-year high, but again, still well below levels seen in 2008/2009 when the measure topped 5.0.
Another important point to consider is the level of cash on corporate balance sheets – $1.5 trillion in the US alone. Ultimately, this cash will be deployed, helping to drive future economic growth. Corporations were not nearly as well capitalized at the time of the 2008 financial crisis.