Lexington, KY - As our economy sputters along, investors speculate whether we will fall into a recession, the future of the Eurozone, and how stocks and bonds will perform through this period of high uncertainty. We are coming off a rough quarter, with the S&P 500 falling nearly 14 percent. Since 1945 (the post WWII era), whenever the S&P 500 fell at least 10 percent, the next quarter's returns averaged 5.9 percent, with positive returns 87 percent of the time. Going back to 1926 shows a 9.3 percent average return with positive results 70 percent of the time following quarterly losses of 10 percent or more.
Over the next few months, it is likely that the market will be driven by sentiment and that sentiment will be driven by politics. In other words, investors will continue to focus on news regarding the endgame in Europe as well as the ongoing deficit problems in the United States.
Europe is very important to the global economy because the European Union is actually the largest economy in the world, with a combined GDP of $16.2 trillion. Europe is working on plans to deal with their debt problems and the probable default of Greece. Specifically, they are in the process of recapitalizing their banks, which would allow the banks to successfully withstand a Greek default. This temporary solution and any longer-term solution will require a tremendous amount of political compromise among the 17 nations making up the Eurozone. While predicting political outcomes is extremely difficult, we think they will come to a solution that will avoid an outright financial crisis.
Assuming there is not a disorderly default from Greece, we should be able to avoid a recession in the near term despite our economy slowing down. The Conference Board's Leading Economic Indicators have pulled back, but remain in growth territory. Rail traffic and auto sales have seen a surge as of late, which are generally positive for the economy. Furthermore, financial conditions, such as low interest rates and a steep yield curve, are accommodative towards a growing economy.
Despite these positive economic contributors, growth is slowing. One of the main reasons is confidence. Consumers remain skeptical of the economy, and this means they are not likely to spend as much as they normally would. Considering spending represents approximately 70 percent of our economy, this is a considerable drag.
As the legendary investor Benjamin Graham said, "In the short run, the market is a voting machine. In the long run, it's a weighing machine." We concede the stock market's short-term movements will be dominated by Europe, but in the long run, earnings will matter most. Earning estimates for 2012 are $95 per share, and this is achievable barring a recession.
Currently, the S&P 500 has a price-to-earnings (P/E) ratio of 13.6, which is well below the long-term average of 16.9. Said simply, companies are cheap compared to how much money they are earning. Based on 2012 earnings, the P/E ratio is even more attractive, at about 12. Let's assume earnings decline by 20 percent to $75 per share, as they might if a recession were to occur. Under this scenario, stocks would still be trading at a relatively inexpensive level, with a 15 P/E ratio. This insinuates that the stock market has already priced in a mild recession.
Thus, exclusive of a deep recession, stock prices are attractive for long-term investors. Within U.S. equities, we favor large-cap stocks that pay stable dividends. The reason for this is better valuation compared to small caps, and their cash flows are attractive in this low interest rate environment.
For international equities, we believe over the next few years emerging markets will outperform developed markets, such as Europe and Japan. The reasons for this are twofold. First, emerging markets are carrying significantly less debt than their developed market counterparts. This means it will be easier for them to achieve stable economic growth. Secondly, investors have recently been apprehensive of emerging markets due to a fear of a hard landing from China, but that is less likely because their growth rate has toned down to a sustainable level.
Assuming our economy remains at a stable growth rate and avoids a deep recession, Treasury bonds are not attractive. After all, who would want to lock up their money in a 10-year bond earning a mere 1.9 percent per year? Looking at yield spreads shows us that municipal bonds are a much more attractive alternative to Treasuries, plus they have the appeal of tax-free interest income.
Putting it all together, as long as we avoid a deep recession (and we think we will), U.S. stocks should perform well over the long run, with large-cap dividend payers leading the way. On the fixed income side, municipal bonds are a nice alternative to Treasuries.
Andrew Stout, CFA is the senior investment officer for MCF Advisors, a wealth management firm with offices in Lexington and Covington.
The views expressed are the opinions of MCF Advisors, LLC and are not to be construed as investment advice. They are subject to error and change without notice. Neither the information nor any opinion expressed constitutes a solicitation to buy or sell any securities or investments. Different types of investments and/or investment strategies involve varying levels of risk, and there can be no assurance that any specific investment or investment strategy will be either suitable or profitable.