Market Memo: It's a grind, and that's OK

As of 09-11-2012

We’re completing a quarter in which growth in the U.S. economy has been slower than in the first half, the Chinese economy has continued to decelerate and corporate earnings have been flattish. So why is the equity market up and setting new cycle highs? It’s up because it’s becoming increasingly convinced that Europe—and the euro—is not going to blow up and, more importantly, that the Federal Reserve and the European Central Bank will provide whatever liquidity is necessary to prevent a downside tail event such as a Spanish default. In the vernacular of the streets, the two central banks have made clear that they “got the stock market’s back.”

Are these people for real?

One of the big unknowns is who is going to win the presidential election and control Congress? It’s very possible the biggest risk the market faces is the November election—we could walk away from it with a split, paralyzed government. Despite truisms such as “Washington gridlock is good for markets,” we see a continuation of the split-government status quo as a negative outcome. Indeed, given the fiscal issues in front of us, we need a unified government to address them. In some ways, our fiscal situation resembles a boat on autopilot heading off Niagara Falls; let’s hope the election gives us one pilot, rather than two fighting over the steering wheel!

In fact, we think the election is going be extremely close—it may come down to a few precincts in Ohio—and may well be determined by which side does a better job of energizing its troops and turning out the vote.

On this front, we have to believe the strike by 26,000 Chicago teachers isn’t doing President Obama or the Democrats any favors. Here you have a school system with a poor record, yet the union is balking over plans for teacher evaluations and modest increases in health benefit co-pays, even though they are coming off a contract that provided total wage increases of 19% to 46% over the past six years and a reported offer to raise wages an additional 16% over the next four years.

Non-government union workers, many of whom are card-carrying Democrats and who have been living without raises, have been laid off or have been forced to work at low-paying jobs, have to be looking at this and asking, “Are these people for real?’’ It’s hard to see how this helps rally the Democratic troops. All it really does is shine the spotlight on sweetheart deals between unions and their political leader, a spotlight Gov. Chris Christie turned on teacher pay and pensions in New Jersey that prompted the national reform effort still painfully underway.

Regardless of how the German courts rule on the eurozone bailout fund this week (Germany's highest court upheld it on Sept. 12), ECB President Mario Draghi has pledged to buy sovereign bonds of European countries in crises. And regardless of exactly what Fed policymakers do when they meet the next two days (they ended up launching a third round of quantitative easing and extending the 0% interest-rate policy to at least mid-2015), Chairman Ben Bernanke has been emphatic that the Fed won’t stand pat. So the tail risk that’s still priced into equities in the post-Lehman bust-up is gradually coming off the table—pricing that’s best measured by the S&P 500’s forward price-earnings ratio. It’s still under 14 times earnings; given where bond yields are, it should by historical measures be at 17 to 18 times earnings.

There are other forces driving equities, as well. The U.S. is the prettiest girl (or boy) in a room of “attractiveness-challenged” global markets. While growth is subpar, its economy is not in a recession and, given recent retail sales, housing and services data, doesn’t appear headed for one. U.S. companies have shown they can make money in this blah environment—profit and top-line growth may be growing very slowly, but with input costs so low (wage inflation is nonexistent) and money historically cheap, margins are holding up relatively well. Balance-sheet wise, U.S. companies are in great shape, with lots of cash, and low, manageable debt.

So what we have while waiting for a major market-moving event—perhaps the presidential debates, the Nov. 6 election or negotiations over the looming fiscal cliff (see accompanying sidebar)—is a market that grinds higher with little enthusiasm, with money going to equities because they are the best game in town. In some ways, the U.S. equity market—and in actuality, U.S. corporations—are serving as a sort of haven amid all the global uncertainty, helping the market hold gains. Maybe investors would prefer to be elsewhere, but there are not a lot of other places they can go with confidence, so they sit it out, waiting to see if something happens to change their course.

The bottom line is the market doesn’t need a ton of growth to grind higher in this environment; it just needs continued growth and a growing awareness that a big downside event is not forthcoming. As a result, we believe it’s prudent to remain cautionary bullish, which is where we stand now in our model stock-bond portfolio, with a 40% overweight position on equities. That’s down from a larger overweight earlier this year, a reduction made in late July in part to take some profits as we close in our 1,450 target on the S&P for the year—a target that, as of this writing, is less than 15 points away. We’ll revisit our stock-bond allocations in a few weeks and will keep you posted of any changes.