As of August 9, 2011, the markets are down about 15% since the beginning of July (www.finance.yahoo.com). The United States federal credit rating has been downgraded for the first time in its history so we are indeed sailing in unchartered waters. Here is a broader view of the current state of markets that we hope will give you some perspective beyond the immediate headlines.
Since 1962, there have been 25 market corrections greater than 10% during bull markets. The average correction was 13.2% and lasted 118 days. Nine of those 25 corrections resulted in bear markets (defined as corrections of 20% or more), which means that 16 out of 25 times, the bull markets persisted after the correction (Laszlo Birinyi). Put another way, based purely on this data from recent history, there is a 64% probability that this correction, as scary as it may be, is merely a correction and not the start of a new bear market.
No matter how we feel, the news is never all bad, and begin with the case for optimism, followed by the case for pessimism and finally, with some closing thoughts.
The Case for Continued Optimism. The U.S. has a lot going for it even as we grapple with a series of monumental changes and challenges. If we take a step back from the headlines, we find it hard to be bearish over long term when you consider the following:
- Corporate profits remain robust. To date, approximately 80% of the companies included in the S&P 500 have reported their most recent quarterly results and both aggregate corporate earnings and revenue were both up about 13% from the year-ago period (Yardeni Research). American corporations have demonstrated that they can make a lot of money even if the economy is not operating at full speed.
- Stock market valuations are cheap. In terms of valuation, the run of strong earnings combined with declining stock prices translates into some attractively priced stocks. Investors can buy earnings for less. As recently as August 4,2011, the S&P 500′s composite Price/Earnings (P/E) ratio, based on forward earnings, stood at 13.15. To put that P/E ratio in perspective, the long-term average ratio is closer to 16 (Bloomberg).
- Cash is still king. Corporate cash balances are at record levels. A growing number of companies are using some of their cash to buy back shares and raise dividends.
- Consumer balance sheets have gotten much healthier. Over the last three years, American consumers have gotten better control over their household finance (www.research.stlouisfed.org). It appears that as a whole, we are spending less and saving more.
- World- wide demand is growing. New car sales are up 5.8% year-over-year (Fidelity). The reality is that even reluctant consumers eventually will have to replace big-ticket items (cars, refrigerators, etc.) as they reach the end of their useful life. The same holds true for business consumers. As global growth expands, we expect the U.S. consumer to shoulder less of the world-wide buying load as demand for consumer goods picks up in other parts of the world.
- Oil prices have dropped. We have seen a quiet, but massive correction in oil prices. Since April, oil prices have dropped a whopping 30% (www.finance.yahoo.com). Lower oil prices are good both for individual and business consumers as it cuts the cost of doing business.
- The Fed continues to maintain very low borrowing rates. The Federal Reserve pledged for the first time to keep its benchmark interest rate at a record low at least through mid-2013 which could help spur growth (New York Times, August 10, 2011).
- The unemployment rate has improved slightly. Even though the unemployment rate remains high, unemployment fell slightly in July to 9.1% (www.bls.gov/cps). More than the slight decline, it is the breakdown that we find encouraging. While governments are slashing jobs to reduce spending, the private sector is adding jobs.
The Case for Pessimism. Lest we appear overly optimistic or blind to the serious issues we face, we also want to acknowledge there are a number of crucial challenges that are having or could have a negative impact on our economy and the markets. Here are some of the headline-grabbing challenges we see now and in the near future:
