Continuing Adjustment to Moderate Growth
Someone recently asked me if I recalled a period during the past 45 years similar to the current one for the economy and markets. While different in some ways, the 1970s, especially the latter five years of that decade, were a time when a malaise fell upon the economy and the markets. Little seemed to be as good as it was in the 1960s when the economy grew strongly, inflation was low and the U.S. was supreme on the world stage. The 1960s was a period of happiness until the latter years of that decade when a growing sense of unhappiness began to develop. Similarly, the 1980s and 1990s were a period of rising happiness as more people nationally and internationally prospered. However, since 2000, like the 1970s, unhappiness has grown from rising recognition that the factors producing the happiness of the previous 20 years were changing. For most of us, the adjustment process to slower growth and volatile markets is not easy. Moreover, the future suggests high debt levels and large deficits for governments and slow growth. Consequently, any short term disappointments, such as weaker than expected housing or employment, cause perceptions which are already negative about growth longer term to become negative short term as well. The feedback short term from a shift in perceptions can indeed cause the effect that produces the worry, slower or no growth, as businesses do not aggressively expand employment or facilities because of their concern about future growth. In order to break this linkage, either more positive fundamental trends need to develop or investors must begin to believe that the current environment is not as bad as perceived. At either point, conviction and confidence can return to the markets and the economy for awhile.
Year to date, the S&P 500 is down 8%, which is a better performance than most world markets. For the second quarter, the S&P fell 12% and since the April market high, the S&P is off 15%. Recall our earlier observation that a big run in the market such as experienced since last spring was usually followed by a 10-30% correction before moving higher. So far the correction since the April high qualifies as a correction in a cyclical bull market that has been in place since March 2009.
Fundamentally, we do not expect a double dip in the economy. Slowing growth in the second half of this year to 2.5%-3.0% is still growth, not a dip. Nonetheless, this level of growth will do little to help expansion of employment. For the U.S. economy to expand, sectors other than consumption, such as capital spending and exports need to grow. Profits will likely rise but at a slower pace than in the first half of 2010. So we presume a moderate level of growth in the economy and profits will persist. European growth may remain slow and Asia may see some moderation in growth.
The markets’ technical structure is worrisome and we believe the principal driver of market weakness this year has been technical led by the disciples of the Elliott Wave Theory, who suggest new lows for the market in the coming years. This outcome could develop if a malaise of unhappiness grows over time and investors become more risk averse. In the months ahead, it would not be surprising to see the S&P 500 move below 1000. In our view the technicals remain troubling.
Having said this, the markets over the next month will be focused mostly on profits reports. While macro indicators will still be watched closely, the micro earnings reports, absent in recent months, will take on added significance. With these reports, we will learn how much of any profits moderation is being discounted in stock prices.
So far this year, the gap between the performance of value and growth has narrowed with value still leading growth by a small margin. Typically value stocks perform best in a recovering economy. Growth stocks perform well when overall growth of profits moderate as is likely in the months ahead. The best values in the stock markets are quality, established growth companies trading at 8-13x 2010 earnings projections with current yields of 2-5%. Typically, these stocks are shelters from a stormy market. We believe they provide opportunity in the current markets.
A. Marshall Acuff, Jr., CFA
Chair, Cary Street Partners Investment Committee
Cary Street Partners Investment Advisory, LLC