For the first time since mid January, the markets have been under pressure. The last correction lasted roughly three weeks and resulted in a market loss of approximately 7% from the January peak to the February trough. This correction has lasted a little over two weeks and has resulted in a slightly larger market loss of roughly 8% so far. Fortunately, the overall bullish trend remains intact, with the correction in January eventually reversing course and leading to new highs and the current correction not breaking the former February lows. In technical parlance, this means that the bullish trend of higher highs and higher lows remains intact. An additional decline of 6% or more to the 1050 January lows would give rise to greater technical concerns.
The current correction feels worse, however, than the one experienced a couple of months ago. The solvency of Greece has reared its head in a far uglier fashion than it did in January, when the country’s economy was dismissed as too small to affect the worldwide stage. Recently televised riots on the streets of Greece, a collapsing Euro, and ineffectual monetary policy efforts by a politically divided EU have all heightened concerns and comparisons of the current Greece “fire” to our own mortgage mess a couple of years ago. While our banks and financial system is much less exposed to Greek and European debt than the European banks were exposed to our own mortgage problems, our Fed and Treasury departments also stood united in doing whatever they could to prevent the second coming of a Great Depression. The temporary but rapid downturn in the U.S. markets on “Fat Thumb” Thursday over the course of twenty short minutes has, no doubt, damaged the psyche of the average investor, just now coming to grips with the prospects for economic recovery.
For sometime now, we have been forecasting a year end target of 1250 on the S&P 500, which at the writing of our last update was a modest 5% upside. We have been preaching a policy of “shifting gears” in preparation for a transition from economic recovery to one of potential expansion. One indicator that we follow widely is the ISM Index, which is a monthly survey of some four hundred purchasing managers from twenty different industries in all fifty states. The survey covers purchasing managers views of production, employment and new orders, among other factors, and has been a good leading indicator of turning points in the macroeconomic cycle and the stock market. Historically, a reading above fifty indicates that the domestic economy is in an expansion mode.
Last week, the survey reading for March was released and came in at 60.4, well within expansion territory. The current debate among top strategists we follow on Wall Street is whether this level, achieved only fourteen times since the survey’s launch, represents an imminent peak in the index measurement or whether or not it can remain at these currently high levels for an extended period of time.
Our take has largely been the latter; employment is just now starting to improve, with 260k new jobs announced last week, the best measurement in a few years. At the margin, we believe employment is a lagging indicator, one only likely to increase as business confidence reaches sufficient levels. While recent earnings results have been outstanding, they have also remain couched in terms of cautious optimism. It is doubtful that companies would finally begin hiring again if they thought an imminent downturn was at hand or if their optimism were set to wane.
Having said all this, we have been shifting gears not based on a peaking in the ISM index, but under the assumption that it can stay higher for awhile. Rather than become more defensive by repositioning the portfolio into safer sectors like utilities, staples, and health care (as would be warranted by a peaking in and downturn in the ISM), we’ve chosen instead to focus on later stage cyclicals that stand to see gains as the economic velocity is maintained and early stage cyclicals that have not yet participated in the markets recent gains, but could be expected to particularly as hiring resumes.
Until Greece’s problems surfaced with renewed fervor in the past two weeks, China was the sole economy experiencing difficulty, a factor I attributed to their earlier monetary policy tightening campaign relative to others around the world. Measured from the perspective of their stock market, China had been one of the few markets down on a year to date basis. Such downward blips aren’t unusual at the start of tightening campaigns, but often prove short lived. (See our Economic Update, Fun with Charts .)
Many years ago, I had the opportunity to hear Margaret Thatcher speak to the clients of a former employer on two different occasions. Both times, she was adamantly opposed to the common currency movement “the Euro” spreading its way through Europe. If my memory serves me right, she believed that monetary unity in the absence of political unity could be a huge policy mistake. For Europe’s sake, and potentially even our own, I hope these countries find the wherewithal to work together before it is too late. In the absence of a unified front, the best defense for U.S. investors – if it comes to that – may be a purely domestic approach to investing, based on those that don’t have any foreign sales or, if they do, would face limited losses due to the depreciating Euro. Such an environment might be manageable, but would hardly be ideal.
At this point, I am sticking with the view that the U.S. recovery, though shaken by the events of the past two weeks, will remain on track. Yet at the same time, I am curious to know what the bad news coming out of Europe might mean to the average views of purchasing managers who participate in the monthly ISM survey. If Europe doesn’t get its fiscal house in order soon, budding domestic optimism could quickly turn pessimistic. Monetary policy and fiscal bailouts should indeed be solutions of last resort, but with few if any in the private sector stepping forward to buy distressed assets, now may be such a moment for Europe.
Ever since I was a kid, visiting firemen and acting Scoutmasters would remind me to never try putting out a grease fire with water. The seemingly obvious and instinctive approach will only make matters worse by spreading the liquid grease, as it flames even faster. The best approach is to smother the problem with heavy rags, denying it the oxygen it needs to keep burning.
For the first time in over a year, I find myself staring at a problem that needs a good smothering. Hopefully, the Europeans will prove as creative in their approach to new problems as our own Fed did over the course of the past two, very trying years.