In August, equities had a strong month in spite of an especially weak earnings season. They seemed to respond to the plethora of comments from central bankers and politicians who act confidently that their words and strategies can forever enable investors to avoid losses. Good luck with that. Without a doubt, we are at a critical historical juncture because of the credit drama in Europe, profound Chinese economic weakness, and soft growth in a U.S still mired in the aftermath of the housing bubble.
As we see it, corporate earnings have clearly begun to roll over and recent global manufacturing indicators demonstrate we are at or near a recession. Because the economic cycle has now rolled over globally, central bankers must fight both the downside of the business cycle and the downside of the secular debt growth story discussed above. Again, good luck with that! Maybe they will be hugely successful, maybe they will not.
The talking heads and pundits espouse that U.S. equities are cheap based on current (likely) peak earnings or relative to treasury yields. Well, the first measure ignores the fact that earnings for the market typically fall about 30% from the peak during a recession. The second measure ignores the fact that measuring stock valuations relative to treasuries has not been reliable over much of market history; it’s comparing apples to oranges.
What’s more, reality has a funny way of intervening in central planning. For instance, money velocity in the U.S. just hit a multi-decade low in the face of enormous quantitative easing by the Fed as consumers and businesses hoard cash. In other words, the Fed can throw a lot of money at the economy, but it can’t force its use. In Spain, a major European trouble spot, capital flight out of the country has reached alarming levels even as the ECB is supposedly set to start a new round of Spanish debt purchases. Consumers and businesses are voting with their feet, confounding stabilization efforts. Inventory levels in China are skyrocketing according to numerous sources in spite of efforts by leadership there to make the economy more consumer-spending oriented after years of a centrally planned infrastructure binge. Things do not always work as (centrally) planned.
To say the least…these are interesting times.
Scott Brown, September 4, 2012