Fear Factor

Posted on July 14, 2010 by David Laidlaw 

At the height of the reality show craze earlier this decade, NBC aired a show in primetime called “Fear Factor” that had contestants perform stunts that appeared frightening or stomach turning.  Most of the challenges involved dangling participants from heights or plunging them into vats of snakes or insects.  Given either innate courage or a strong desire to capitalize on their 15 minutes of fame, most of the show’s contestants gamely withstood the challenges without faltering.

Over the past two months, investors have been subjected to harrowing global/economic challenges that threaten to plunge the world into a second financial crisis or global slowdown.  The two most serious threats are the impending restructuring of Greece’s, and possibly other Mediterranean countries’, sovereign debt and the oil spill in the Gulf of Mexico.  The Greek government does not have the financial wherewithal to repay its looming debts without substantial assistance from the rest of Europe, especially Germany.  The issue that concerns the markets is whether or not this sparks a contagion that spreads to larger countries such as Spain and Italy, similar to the way the Bear Sterns’ failure eventually infected Lehman Brothers and the rest of the investment banks.

While BP’s oil spill is regional in nature, this environmental catastrophe destroys optimistic views of technological progress and mankind’s relationship to the ecosystem.  It’s a technological triumph that we are able to extract oil from a mile below the ocean’s surface, but the spill highlights human frailties.  These weaknesses include the complete lack of contingency planning for what should have been expected emergencies and greed associated with trying to cut costs to wring every last dollar out of the project. 

The spill also highlights our country’s complete lack of a coherent energy policy.  Our transportation networks and whole economy depend on cheap hydrocarbons, the majority of which are imported.  Our pursuit of alternatives is half-hearted as NIMBY (not in my back yard) concerns derail efforts to tap alternative sources such as wind.  Similarly, the government streamlines the application procedure process for nuclear reactors, but pulls the plug on developing a safe place to store the waste. 

These events caused the equity markets to shed roughly 12% during the Second Quarter.  Similar to previous downturns, the bond market has rallied pushing the yield on the 10-year US Treasury to below 3%.  These numbers, especially the historically low bond yields, suggest a long period of recession or below average growth.  Why else would anyone buy a bond paying 3% a year that doesn’t mature for ten years unless his or her forecast was exceptionally gloomy?

Even given these troubling conditions, we do not believe that this year will devolve into the meltdown the markets experienced in 2008.  Conditions are different now and the economic fundamentals are not as precarious. 

For example, US GDP grew at over 5.5% during the 4th quarter of 2009 and at a rate of 2.7% during the first quarter of this year.  While most growth forecasts have decreased, economists still predict the US economy will grow at a rate of approximately 3% this year.  These trends show that the economy is still recovering and not slipping into another extended recession. 

Further, the global banking system is much stronger than it was in the build-up to the credit crisis.  The large banks had tangible capital ratios of 1.2% (Citi) to 3.3% (JP Morgan) at the end of 2008.  After governmental cash infusions and more importantly very strong earnings due to solid interest margins and trading revenues, banks now have fortress balance sheets with well over 5% of tangible capital.  Lending is also already tight so that the current problems will not induce huge limits on borrowing.

Profits at publicly traded companies are now expanding rather than contracting.  In 2007, profit margins reached a high water mark and expenses were expanding.  In response to the credit crisis and recession, corporations pared work forces aggressively, thus reducing expenses.  This combination of renewed growth plus expense reduction has led to strong earnings.  During the 1st Quarter, earnings at the S&P 500 companies were 51% higher than during the first quarter of 2009.  Analysts expect this rate of growth to slow; however, profits for the second quarter this year are still expected to be 34% higher than last year’s comparable quarter. 

Finally, equity prices are very depressed relative to these earnings and cash flow figures.  In 2007 and early 2008, the general price level was significantly higher than it is now with the S&P 500 trading over 20X predicted earnings.  As of June 30th, the S&P 500 was selling for about 12-13X expected earnings.  Stated differently, the earnings yield on stocks (earnings/price) is about 8% compared to 3% for bonds.

The negative news emanating from Europe will most likely slow global growth and the Gulf spill depresses spirits.  However, the domestic economy is still growing as are many emerging markets.  Stock prices are inexpensive and expectations are extremely muted.  Therefore, we view the current market as a buying opportunity rather than a value trap. 

While BP’s oil spill is regional in nature, this environmental catastrophe destroys optimistic views of technological progress and mankind’s relationship to the ecosystem.  It’s a technological triumph that we are able to extract oil from a mile below the ocean’s surface, but the spill highlights human frailties.  These weaknesses include the complete lack of contingency planning for what should have been expected emergencies and greed associated with trying to cut costs to wring every last dollar out of the project. 

The spill also highlights our country’s complete lack of a coherent energy policy.  Our transportation networks and whole economy depend on cheap hydrocarbons, the majority of which are imported.  Our pursuit of alternatives is half-hearted as NIMBY (not in my back yard) concerns derail efforts to tap alternative sources such as wind.  Similarly, the government streamlines the application procedure process for nuclear reactors, but pulls the plug on developing a safe place to store the waste. 

These events caused the equity markets to shed roughly 12% during the Second Quarter.  Similar to previous downturns, the bond market has rallied pushing the yield on the 10-year US Treasury to below 3%.  These numbers, especially the historically low bond yields, suggest a long period of recession or below average growth.  Why else would anyone buy a bond paying 3% a year that doesn’t mature for ten years unless his or her forecast was exceptionally gloomy?

Even given these troubling conditions, we do not believe that this year will devolve into the meltdown the markets experienced in 2008.  Conditions are different now and the economic fundamentals are not as precarious. 

For example, US GDP grew at over 5.5% during the 4th quarter of 2009 and at a rate of 2.7% during the first quarter of this year.  While most growth forecasts have decreased, economists still predict the US economy will grow at a rate of approximately 3% this year.  These trends show that the economy is still recovering and not slipping into another extended recession. 

Further, the global banking system is much stronger than it was in the build-up to the credit crisis.  The large banks had tangible capital ratios of 1.2% (Citi) to 3.3% (JP Morgan) at the end of 2008.  After governmental cash infusions and more importantly very strong earnings due to solid interest margins and trading revenues, banks now have fortress balance sheets with well over 5% of tangible capital.  Lending is also already tight so that the current problems will not induce huge limits on borrowing.

Profits at publicly traded companies are now expanding rather than contracting.  In 2007, profit margins reached a high water mark and expenses were expanding.  In response to the credit crisis and recession, corporations pared work forces aggressively, thus reducing expenses.  This combination of renewed growth plus expense reduction has led to strong earnings.  During the 1st Quarter, earnings at the S&P 500 companies were 51% higher than during the first quarter of 2009.  Analysts expect this rate of growth to slow; however, profits for the second quarter this year are still expected to be 34% higher than last year’s comparable quarter. 

Finally, equity prices are very depressed relative to these earnings and cash flow figures.  In 2007 and early 2008, the general price level was significantly higher than it is now with the S&P 500 trading over 20X predicted earnings.  As of June 30th, the S&P 500 was selling for about 12-13X expected earnings.  Stated differently, the earnings yield on stocks (earnings/price) is about 8% compared to 3% for bonds.

The negative news emanating from Europe will most likely slow global growth and the Gulf spill depresses spirits.  However, the domestic economy is still growing as are many emerging markets.  Stock prices are inexpensive and expectations are extremely muted.  Therefore, we view the current market as a buying opportunity rather than a value trap.