Posted on October 10, 2011 by David Laidlaw

After a quiet winter, spring and early summer, fear has predominated all of the markets since August. The S&P 500 dropped about 14% during the third quarter. Oil has also sold off and even gold, viewed as a safe haven, has lost about 15% of its value since it peaked in late August. The market movements have also not been steady with violent swings of 2-4% in price changes per day.

The main reason for the return of the fear trade is the weakness of European sovereign debt. Greece’s contagion could spread beyond Ireland and Portugal to Italy and Spain which have more than $1 trillion in outstanding debt that may not be repaid. Default on this debt could then cause immense capital losses at banks throughout Europe including the very large French banks such as BNP, Credit Agricole and Societe Generale. The assets of France’s three largest banks represent 294% of France’s GDP compared to our three largest banks which have assets of about 36% of US GDP. 

A worst case scenario has the potential to produce a disorderly default by numerous governments, as well as bank failures. Economic activity in Europe would contract drastically, similar to what happened in 2008. This contraction has the potential to cause a global recession since Europe’s combined economies represent a large percentage of world- wide demand.

One new element that appeared over the past month or so has been the weakness in the Emerging Markets which were previously viewed as safer bets due to their more vibrant economies. Currencies in these markets have fluctuated downward as fear increases that the loss of their exports will hurt their domestic economies. For example, Brazil’s Real depreciated by roughly 16% versus the US Dollar since the middle of the summer.

While we recognize these risks, we still believe that this worst case scenario will not materialize. While quite weak, our economy is still growing. China’s growth has slowed, but that country is still reporting high single digit growth rates. We also believe that Europe will protect Italy and Spain even if Greece defaults, given the terrible consequences of letting the whole currency fail.

Bonds continue to provide no potential for long-term returns. That said, we do not recommend exiting these safer assets since risk of loss is still high in the equity market over the near term.

Stock valuations are approaching where they were in March of 2009. The S&P 500 is selling for an average Price to Earnings ratio of 12X full year 2011 earnings. Many companies with strong growth potential are also providing dividend yields of 2-3%. From the lows reached in 2009, stock prices had almost doubled through the Spring of this year. Even after this recent period of volatility, stocks are still up 62% since then. We do not expect anywhere near as sharp a rebound as before, however, stocks will eventually rally producing much better returns than available in bonds.

Corporations are still incredibly profitable due to huge productivity gains made during the past four years. Companies have also strengthened their balance sheets so that they are able to withstand shocks to their financing much greater than have materialized so far. For example, Microsoft has about $52 billion in cash and marketable securities on its balance sheet. While the short-term risks are high, we see the potential for price appreciation in quality companies that are selling for depressed valuations.