Third Quarter 2011 Review and OutlookConcerned about a potential slowing of global economic activity, investors sold stocks worldwide over the past few months. It was one of the worst short-term selloffs ever. Through the first nine months of the year the Standard and Poor’s 500 Index declined 10%. Broader indexes such as the Russell 2000 and the Value Line Index fell even more, 18% and 20%, respectively. Off their April peaks the latter two indexes declined 30% and 28%. Globally, declines were worse. Most foreign markets fell between 15% and 25% through the first nine months. Even gold, viewed as a safe haven, dropped 12% in just the span of a week.
During the quarter, an international flight to safety took place as money flowed into the U.S. This was most notable via the weakness in foreign currencies, particularly those of emerging markets. Investors purchased money market funds and short-term Treasuries where yields are almost zero—effectively accepting a loss when you factor in a 3 ½% inflation rate.
Two primary issues are particularly weighing on the financial markets:
The immediate concern is Greece where uncertainty reigns supreme. On one hand, many say let them fail and start over. On the other hand, the fear is that Greece’s default could cascade through the other debt-laden countries of Europe triggering a much larger problem for the European financial system. In the latest update, Germany and France have assured the world they are going to backstop the European debt problem. In any event, their problems do not appear nearly as grim as the financial crisis we experienced here in 2008.
While not as urgent, our ever growing U.S. government debt is a much larger and looming problem. Unlike Greece, a default here would be horrific. Congresses inability to constructively deal with future entitlements and their inability to cut spending has to change. In addition, policies coming out of Washington need to become much more business friendly if the government expects companies to remain here, invest, grow, and generate additional tax revenues. The debt clock is ticking and everybody knows it.
Wall Street and the financial markets may have overreacted to these concerns when contrasted to what is actually taking place on Main Street though. While forecasts of a double-dip recession increased this quarter most economic indicators remain neutral to slightly positive. Anecdotally, auto sales were up nicely last month and Federal Express just announced that shipment volumes through September, year-over-year, increased 3% both here and abroad. Lastly, in spite of our high unemployment rate, retail sales increased 5.7% in September over last year’s number.
Of the thirteen bear markets since World War II the median decline has been 27% and the duration about 6 months. Looking at the broader indexes with declines already near 20%, the worst may be over for stocks. Based upon the earnings for the S&P 500, stocks are now trading at levels lower than the average lows reached during most other recessions.
Until now, the current environment has led us to skew investments towards convertible bonds, higher yielding stocks, and cash. Looking forward, however, long-term investors should be rewarded in both convertible securities and common stocks from these market price levels, particularly when our debt and business policy issues get real attention. We are very optimistic about the Congress addressing these problems in 2013 after next year’s elections. It should give a real boost to the economy and stock prices alike.
As always, we thank you for your continuing support.
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