Fagan Associates Archive for June, 2011

The stock market has sold off approximately seven percent over the past eight weeks as investors have recently chosen to view the economic glass as half empty rather than half full.  With this in mind, as part of a two part series, last week we addressed five negatives that were weighing on the stock market, including the weak housing market, high unemployment rate, austerity measures proposed at all levels of the public sector, the paradox of thrift and a heating up of the political rhetoric.  This week, we’ll address some of the positives that should ultimately take hold and send stocks higher or at least provide a floor within a few percentage points of current levels.

The first positive is that given current valuations stocks have most likely already factored in the weak housing and labor markets and that only a further, marked weakening, will send stocks lower.  If history is any guide, the housing bubble which was pricked during the latter part of 2007 and into 2008 will at some point recover a small portion of their losses and then flat-line for awhile.  In other words, the bloom is off the housing market rose.  However, absent a further decline, most homeowners are not assuming any appreciation in the value and most investors are not assuming that the housing market will participate in an economic recovery.  Any upside in the housing market will be welcomed by homeowners and investors alike.

The second positive is that interest rates on deposits remain at or near zero percent.  Individuals either saving for the education of their children, their retirement or receiving retirement income are not able to achieve their objectives with money earning zero.  They will look for alternatives which will include stocks as well as bonds.  And why not, many individual stocks pay dividends far in excess of three percent as do mutual funds.  Many individuals will shoulder some risk to principal for an opportunity to pick up a return better than nothing, which is what money in the bank is paying.

The economy continues to move forward, albeit at a sluggish pace.  Given all of our economic woes noted above as well as others, it is no surprise that many believe our country remains in a recession.  The fact of the matter is that we are moving forward, it is just not at a blistering pace.  And for every month that passes, our economy continues to heal – individuals repair their balance sheets, corporations earn money and the public sector right-sizes.  Ultimately, this will lead to a more robust recovery assuming that there are no external shocks to the economy.  (We realize this is a big assumption.)

The United States is a smaller contributor to global economic growth.  This may sound like a negative, but it is not.  The global economic pie is getting bigger and despite the fact that our percentage of this pie is shrinking, the absolute value of that pie continues to rise.  The vast majority of S&P 500 companies derive more than half of their revenue and net income from outside the United States.  This bodes well for corporate earnings which should eventually help lower our unemployment rate.

The final potential positive influence on stock prices is the high degree of skepticism and cynicism on both Main Street and Wall Street.  The stock market has gone nowhere for the past twelve years and investors are beginning to wonder if it will ever rise again.  What they don’t know is that this market action is very similar to past cycles where stocks appreciate over a longer period of time which is then followed by a digestion of those gains over a similar period of time only to then be followed by another long period of appreciation.  We believe at some point in time increasing corporate profits and improving fundamentals will ultimately push stocks higher.  When this occurs is anybody’s guess.  However, we do know that the time will come when stocks have their day.

THE BOTTOM LINE – Remain patient.  Invest according to your objectives and recognize that despite all of the negativity in the media surrounding the stock market, there is a lot of value out there, value which we believe will be unlocked over the next two to five years.  We conclude that stocks remain the nicest house in a bad neighborhood and at this time the most efficient choice in helping you reach your financial objectives, when compared to bonds, cash and real estate.

An article appeared in the financial newspaper, Barron’s this past weekend in which columnist, Lawrence C. Strausss interviewed Paul Hickey and Justin Walters, the founders of Bespoke Investment Group.  Within the article, Walters was asked, ”Why are you bullish?”  His response puts in a nutshell why we remain cautiously optimistic on stocks or at the very least believe the jury is still out regarding the sustainability of this economic recovery.  Walters notes that “obviously the financial crisis of 2008 and early 2009 has made the individual investor and even institutional investors so worried that, any time you see any kind of pullback of 3% or 4%, it seems like people think the world is going to end.  And all of the news just becomes completely negative.”

The stock market has sold off approximately seven percent over the past seven weeks as investors have chosen recently to view the economic glass as half empty rather than half full.  With this in mind, as part of a two part series, over the next two weeks we’ll take a look at some of the positive influences on the stock market as well as the negative.  Given the fact that we are in the midst of a pullback, let’s look first at the negative influences, discussed in order of perceived impact.

The biggest drag on the economy continues to be the weak labor market.  High unemployment has a ripple effect, negatively impacting business and consumer sentiment and therefore business and consumer spending.  Historically, at the height of an economic recovery the Unemployment Rate gets below five percent to a rate that many consider full employment.  With unemployment hovering around nine percent, we believe that it will be a period of two to five years before we achieve such low unemployment rates.  This is due to the fact that what historically leads the United States economy out of recession is the housing market which remains in a funk as we will discuss below.  Given the bubble in housing during the last economic expansion, the Unemployment Rate may not get much below six percent during the height of this expansion.

The second issue negatively impacting our economy and therefore the stock market is, as noted above, the weak housing market.  In fact, it would be easy to cite the housing market as the main culprit for the deep recession and relatively weak recovery, thus far.  Quite often when a bubble bursts in any sector of the economy, it takes many years for that sector to recover to its prior highs.  We believe that this will be the case with the housing market as many potential homebuyers are reluctant to step in and buy due to a continuance of falling prices in housing, relatively cheap rents and a weak labor market which adds future economic uncertainty. 

The third economic drag was the catalyst behind economic growth over the past decade and that is public sector spending and hiring.  Now without getting into any political debate, let us state that, in the aggregate, the public sector is responsible for every job created in the United States since 1998.  Without the public sector, the U.S. would have experienced a contraction in the labor market.  Like it or not, the public sector right on down from the national level to the municipal level must curtail spending and therefore hiring as it tries to “right-size” itself for the economic climate and projected tax revenue.

The fourth economic drag is the paradox of thrift.  Americans are in the process of repairing their balance sheets.  For the fifteen year period including 2008, the average American spent more than they took in by borrowing more on their credit cards, home equity loans or by dipping into their savings accounts.  We are in the process of reversing this trend and unfortunately, this process will take a bit of time.  It is very similar to dieting.  You are not just going to wake up thinner.  It will take time, effort and discipline.  Correcting the excess in credit will also take time.  Once again, this will be measured in quarters and years, not months.

The political rhetoric will heat up.  Historically as this occurs, public sentiment tends to sour.  When public sentiment sours so does investor sentiment and the stock market has a difficult time making headway.  It appears as if the Presidential Election rhetoric has already began.

Global geopolitical risks will remain on the front burner.  Portugal, Ireland, Italy, Greece and Spain (PIIGS) will continue to make negative headlines as they try to fix their debt-laden budgets by perhaps restructuring this debt and by reducing spending in their public sectors.  European Monetary Authorities continue to try to buy time and taking several measures.  Once again, whether it works or not will take quarters and years rather than months.  One can also not ignore the Middle East which remains a hotbed of political tension.

THE BOTTOM LINE – Keep in mind that this column was intended to be negative.  Next week we will cite the many positives which if nothing else should provide a floor near current levels.  We will conclude this article with our current opinion of the potential for investors over a foreseeable time period.