Market Upheavals: Summer of Our Discontent

Over the last two months, equity markets have once again delivered record-breaking volatility along with jaw-dropping declines. The down grade in US Treasury debt by Standard & Poor's and the turmoil in Europe surrounding Greek credit challenges are the primary culprits. Regardless of reason, fear seems to rule the day. At one point in early August, despite any real signs of recession, selling pressure resulted in a ratio of declining stocks to advancing over a day's trading of 77 to 1, a level not reached in the last 80 years! The result was a blood bath of short-term losses that rocked the investment world and shortened the vacations of nervous hedge fund managers and short term traders. The press, of course played its part suggesting comparisons with the 2008 debacle, creating the impression that the sky was indeed falling, and opening the door for emotions to overwhelm rational reason.

What, me worry?

While we at Dowley & Company have been known to be optimists, I think we are well within the bounds of credibility and we seem to have lots of company. Yes, the economy is not exactly firing on all cylinders, while unemployment remains stubbornly fixed and seems content to remain so. And the EU? Well they seem to despair at the tough choices around Greece and how to handle it all. When you look at it, it does seem pretty ugly, doesn't it?

Not so fast

There is a big difference between economies and markets. Economies grow (or not) and change with the pace of a tortoise while markets leap about like so many hares on amphetamines. The US Economy is growing, despite all the evidence in the press to the contrary. One percent seems to be the annual estimate at last look. Growing slowly, but growing nonetheless. Consumer debt is shrinking, as indicated by the numbers of defaults on revolving credit. As of the end of the second quarter of this year, over 75% of the S&P 500 companies reported earnings that beat Wall Street estimates. They posted earnings growth of 18% and revenue growth of 13%. They also happen to be harboring a record amount of cash. If you exclude financial stocks from the mix, it is estimated they have approximately $1.75 trillion on the balance sheets. Even if they need to borrow the money for their expansion ideas, interest rates are at record lows and it costs them very little to do so. Access to capital does not seem to be a problem. In case they want to hire new employees, they have what appears to be the largest supply in half a century available at competitive wages given that most of the potential hires would be glad to take a pay cut just to get a job. Wage inflation doesn't seem to be a problem (or any inflation for that matter) nor does the supply of eligible hires.

So why aren't these businesses investing and spending and hiring? Businesses are concerned with return on equity. They want to know if they put their capital to work; it will give them a return that will accrete to the bottom line. The only reason they don't invest in new capital and hire employees is fear of not getting that return. So they do things like increase dividends and share buy backs to improve their stock's market price. Yes the economy may be slow, or slower than we would like. While markets may be depressed on the back of uncertainty in the news, they look like they have earned our optimism.

That leaves only one major unknown: government. I would like to think even politicians couldn't mess this one up. Yet they are so desperate to save their elected hides that they will do almost anything, which is where the problem comes in. I would like to think the legislative environment is accommodative to business, and it probably is right up to next year's election. After that, all bets are off.

So what do we like?

Taking into account that volatility will be the order of the day, our investment team continues to favor equities over fixed income and large cap stocks over small. We like the emerging international markets and continue to allocate assets to that area. We have taken gains earlier this quarter and used the proceeds to reinvest opportunistically where we have found price declines have created value. While we still allocate assets to fixed income asset classes, our managers have tended towards a defensive posture in our core holdings and increased security selection at the fringe. Overall duration is shortened given concerns over rising interest rates. After all, we know they cannot go down forever. The question remains, when they do go up, how fast will it happen? The Federal Reserve may like to broadcast its intentions, but bond markets are not so generous.

A final thought

One investment strategist was quoted recently saying, "When we're getting close to a market bottom, the phone starts ringing off the hook and our clients want us to sell everything. Market bottoms are less about an improvement in the fundamental situation and a lot more about getting rid of all the anxious investors"

No doubt the media will continue to translate the current volatile market conditions into dramatic headlines. No doubt this will continue to feed investors' fears. No doubt some of them will sell everything. Our job is to prevent the market swings from getting rid of the anxious investors, instead helping the investors get rid of their anxiety.