Fighting the Last War

Written by Nathan White, Paragon's Chief Investment Officer

It has definitely been a choppy year for the markets, but as we enter the fourth quarter, there are some signs that the market can end the year on a good note. In January, our best guess at how the year would turn out was that the equity markets would end positive for the year, but it would be a bumpy ride. We warned that this type of environment could easily knock investors off their footing in light of the market crash in 2008 and early 2009. Anyone who sold during the January or summer corrections missed out on the subsequent rallies. It was interesting to note that after an August where the S&P 500 was down about 4.5 percent, how bearish many of our sentiment indicators were and how many traders and hedge funds we monitor were outright bearish and short.

Conversely, our indicators were about 90 percent bullish at that point. The markets then went on to have one of the best Septembers on record even as investors pulled out over $20 billion from domestic equity funds during this month, according to estimates from the Investment Company Institute. That brings the year-to-date figure to over $65 billion taken out of domestic equity funds and over $248 billion into bond funds with interest rates at historic lows!

Referring to the third quarter, a recent Wall Street Journal headline on September 29 read, "Blue Chips Surge 10.4 Percent Even as Small Investors Pull Back". It seems that people are so shell-shocked from the last bear market that when this year started to show some uneasiness, the retail investor quickly headed for the exits. It seems as though investors are so concerned about fighting the last war that they are blind to the fact that things are not as bad as they think, and our situation could actually improve.

REASONS FOR THE UNCERTAINTY AND UNEASINESS

There have been many reasons for the uncertainty and uneasiness. Recoveries never "feel" good, and that is especially true after the last so-called "Great Recession". During the second year of a recovery (this year) the economic data begins to slow and normalize. This slowdown in growth was misinterpreted to mean that the economy was going to contract (negative growth) and enter the much talked about double-dip recession. Add to all of this the uncertainty caused by government fiscal and regulatory policies and European debt concerns. It is no wonder that many have been quick to pull the trigger or avoid the stock market altogether.

We are concerned about the risks arising from the current round of currency devaluations being pursued by the U.S. and many other governments around the globe. In an effort to boost their economies, everyone is trying to gain an edge for their exports by making their currency cheaper than their neighbors. This "beggar thy neighbor" policy can lead to trade wars and capital flow restrictions that would unfortunately echo some of the major mistakes of the 1930's.

Depending on the outcome of the elections, there is still the possibility of continued uncertainty from the negative consequences of fiscal and regulatory policies. Along these lines there is the very real possibility of large tax increases if the Bush tax cuts are not extended, which would have a very real negative effect on the recovery.

There are also significant risks with the ramifications of the Fed's extremely loose monetary policy. It is hard to assess all of the implications of artificially holding interest rates at zero. The Fed's massive quantitative easing is contributing to the misallocation of capital, which could lead to new asset bubbles. How will the Fed extricate itself from its ballooning massive balance sheet that is now set to get even bigger?

While we view these as valid concerns, let me discuss some positive catalysts that could propel the equity markets higher.

POSITIVE FACTORS

In my view, the most significant positive factor right now is the amount of cast on corporate balance sheets. Recent data suggests that companies have about $843 billion of cash on their books representing around 11.5 percent of their market capitalization, which is a record high. Eventually companies must find a use for all of that cash in the form of acquisitions, stock buybacks, dividends, or capital investment by expanding or updating equipment. As the political situation improves, in that we have more certainty due ironically to the prospect of gridlock in Washington, companies will feel more confident to begin developing that cash.

Another factor supporting the equity market is that although the recovery is slow, the economy is still growing. I heard a quote today from David Bianco, head of equity strategy for Bank of America/Merrill Lynch, who said that the "S&P is not U.S. GDP". My take on this statement is that even if GDP growth remains low, companies are operating at such a high productivity level that they will continue to post the current level of earnings growth that makes present valuations inexpensive. Slow growth is slow growth, and in this type of environment it can be crucial to remain invested in order to realize any of the gains that are available.

Fed policy also continues to be accommodative with low interest rates and quantitative easing that provide low financing and capital costs for business and consumers. Stock market valuations are even more compelling when compared to the current low interest rate environment. The Fed is intentionally trying to create inflation to support the economy. The money that doesn't go back to the U.S. government to support spending is going into hard assets like commodities and to a lesser extent the equity market. The old mantra of "don't fight like the Fed" has a lot of truth to it. Do you know anyone else who has a virtually unlimited checkbook?

The markets are also entering the seasonally good fourth quarter (which tends to be very good if September was positive) and the November to May period. Add to this the tendency of the third year of a presidential cycle to be good and that markets tend to perform well when there is gridlock (split government) in Washington, and you have further support for the market to advance. Investor attitudes while now getting better are nowhere near overly optimistic levels that tend to occur when all of the good news is priced in. This suggests that we could have further room to move on the upside as the market climbs the proverbial wall of worry.