Posted on October 26, 2012 by David Laidlaw

Over the last three years, the equity market’s movements have traced very similar patterns during the first half of the year. Each year began with a strong charge of optimism during which the prices for risky assets such as stocks and commodities rose impressively. After the first quarter, the markets faltered and then fell sharply as worries over European solvency in both the banking sector and the weaker sovereigns spread.

During June, Spanish bond yields for 10-year obligations exceeded 7%. There is nothing magic about this level, although, all of the other countries, including Greece, Ireland and Portugal, that had to pay rates this high needed bailouts. However, Spain is a much larger country with greater liabilities than these other weak sovereigns. Italy’s bonds are somewhat more stable, but Italy is larger still (Europe’s 3rd largest economy) and its debt is about 120% as large as its economy. It becomes very difficult for countries to reduce their debt when liabilities are large relative to their economies. Reducing debt becomes close to impossible as economic growth evaporates and rates rise. Imagine trying to pay off a mortgage when one’s salary is being cut, the cost of living is increasing and the mortgage rate itself is climbing.

The last day of trading during the quarter saw stocks rise as it appears that Europe will begin harmonizing its banking regulations. This common regulatory framework will limit the runs on banks which have seen depositors pull Euros from banks in weak countries and deposit those funds in Germany.  

Almost all of Europe is in a recession except for Germany. The Commerce Department reaffirmed that economic growth in the US was a tepid 1.9% during the first quarter. Current estimates call for this rate of growth to expand to about 2.2%, but this number appears subject to downward revision. A manufacturing data point released in early July by the Institute for Supply Management showed contracting activity for the first time since July of 2009 when the country began coming out of the last recession.

China’s economy is also slowing since Europe is its biggest customer. Direct evidence of China’s weakness can be seen in much lower prices for a wide range of commodities. China has been the world’s largest consumer of commodities for quite a while. Oil is down from about $105 per barrel to $86 over the past few months. Similarly, cotton prices have declined over 20% since April 1st.

Against this macro-economic backdrop, common stocks are reasonably valued, while bonds are historically expensive as fear trumps optimism. Valuations between common stocks and fixed-income securities have not changed materially since our last commentary. 10 year yields on US Treasuries touched a low of about 1.45% and have since inched up to approximately 1.60%.  

US Stocks are now more attractive than earlier on a valuation basis. S&P 500 earnings estimates suggest that stocks are selling for roughly 13-14X this year’s expected earnings. Stocks are also providing dividend yields of 2.1% which is more than 0.5% greater than the yield on 10-year Treasuries. International stock prices have fallen further and we are seeing interesting opportunities in foreign equities.

We still believe equities are attractive investments, but do not see any near-term catalysts for rising prices. As discussed, economic growth is lackluster and the world is still deleveraging, which suggests limited potential for expansion until more demand emerges.