Up, Down, Up, Down - Europe in the Balance

Posted on January 13, 2012 by David Laidlaw

No matter from which angle 2011 was viewed, the year was bizarre.  

From late July onward, stock markets throughout the world exhibited extreme volatility, rising or falling a few percentage points each day.  Stocks also moved in lockstep with each other; correlations between changes in equity prices which are normally in the 40-50% range climbed into the mid to high 70% range. Our higher quality stock holdings outperformed the market in the second half of the year as stocks with less certain prospects, such as banks, weakened, but there were many days when most holdings increased or decreased exactly in line with the indices.  

Another odd aspect of the year’s performance was the absence in return differential between our most aggressive and conservative portfolios.  Conservative accounts that we manage contain a high percentage of bonds or bond-based Exchange Traded Funds while aggressive portfolios are fully invested in stocks with only small cash balances.  Most years there is wide dispersion in the performance of these portfolios. For example in 2009, our most aggressive accounts returned about 29% while our conservative accounts gained 15%.  Conversely, in 2008, the aggressive portfolio lost 30% while the conservative portfolio lost 10%.  This year, however, the gap was only about 3% with the all equity account doing better than the balanced portfolio.

Finally, while not odd, a few investment trends reversed themselves.  In 2011, large capitalization stocks outperformed small capitalization stocks for only the third time in the last 12 years.  US stocks performed better than international stocks and gold no longer enjoyed safe haven status as its price sagged from August until the end of the year.

The threat of sovereign debt defaults in Europe coupled with another banking crisis caused this constant volatility.  These threats are novel and there is no way to determine how stocks and bonds would react if European countries defaulted on their debt.  The uncertainty also includes the very real possibility that the European monetary union will disintegrate.  Unravelling millions of contracts denominated in Euros would cause turmoil throughout the markets.  

Liquidity is not the problem.  In early December, markets throughout the world rallied impressively after the central banks of the US, Canada, Europe, Switzerland, the United Kingdom and Japan indicated that they would work together to supply Europe with dollar funding.  Credit in dollars had been difficult for the European banks to obtain given fears that they would collapse.  

Solvency and economic competitiveness are the problems.  Europe’s periphery (Greece, Spain, Italy, Portugal, Belgium and Ireland) have borrowed way too much.  These countries cannot afford to pay the indebtedness back without German support.  Bailouts of all these countries won’t work by pumping more currency into the system alone.

Continued major treaty and structural economic reforms are also necessary.  Most of the recent news reflects that the European governments are working toward a solution for tighter fiscal integration so that the union can limit deficit spending by each country.  However, every individual country in the union will be loathe to cede their sovereignty to set their budgets to a central planning body dominated by Germany.  

Europe’s periphery will not be able to climb out of its debt hole through austerity alone.  The problem countries are uncompetitive and cannot sell their goods denominated in the Euro which is still expensive.  Germany’s GDP per capita was about $38,000 while Italy’s was $33,000 with German productivity increasing at a faster rate.  We still believe that the most likely outcome is an eventual breakup with the strong countries separating themselves or the weak ones forced out of the union.  This would allow less competitive countries to devalue their currencies which would both reduce their debt levels and increase exports.  On the downside, these economies would have to pay more to borrow money.  

Barry Ritholtz who writes the Big Picture blog argued that every market commentator should have to include the following disclosure for any market forecast:

The undersigned states that he has no idea what’s going to happen in the future, and hereby declares that this prediction is merely a wildly unsupported speculation.

That said, stocks should do well based on earnings strength and the fact that the US economy is picking up steam.  On a valuation basis, stocks are also inexpensive.  On a consolidated basis, the earnings yield of the S&P 500 is roughly 8% compared to US Treasuries which yield between 0.01% (3-month bill) and 2.89% (30-year ).   As discussed, the sovereign debt issues and lack of capital in Europe’s banks could derail any positive momentum, but these disruptions would have to be larger than those experienced over the last couple of years.