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December 20, 2012

Beyond Stock Gloom

Investors have reason to be nervous. But look again.

Since the recovery from the worldwide financial meltdown commenced in 2009, global stock markets have closely mirrored international economic fundamentals: lots of false hopes and liquidity-driven bouts of enthusiasm followed by regular sharp corrections. The recovery has been sluggish, at best, and stock market rallies have lacked a solid foundation. On balance, the Global Dow Jones index has been in a holding pattern, trading in late 2012 very close to where it stood three years ago.

Individual markets have been extremely uneven—which is also true of the global economic recovery. It used to be that whenever the United States sneezed, the rest of the world, and especially emerging economies, caught pneumonia. From 2009 to 2011, however, China jumped-started its economy well ahead of the rest of the world. It became the world’s largest market for motor vehicles, leapfrogging the depressed U.S. and helping sustain the crucial automotive industry in North America and Western Europe.

Insatiable demand for commodities from Chinese manufacturers also helped oil, metals and food exporting nations around the world to grow strongly. 

Rich Country Malaise

Overall, emerging economies have outperformed rich countries on the road. Over the past four years economies such as Brazil, India, South Africa, Russia, Turkey and Indonesia have come into their own. 

At the same time, rich industrial nations have underperformed. Japan has now sunk into perpetual stagnation and few analysts expect anything from its economy or stock market. Europe has become split into creditors and debtors, with disastrous consequences for the economies of the southern periphery, which have entered an open-ended recession. The Madrid and Milan stock market indices lost half of their value between early 2010 and mid-2012. The FTSE MIB index in Milan is down some 75% from its 2008 peak.

Until late 2012, Germany had benefited from the euro-zone crisis. Money that fled from debt-ridden countries found a new home in Germany. German borrowing costs fell to zero, and the weakness of the single currency stimulated German exports outside the euro-zone, making up for soft demand in Europe. The DAX index in Frankfurt has held up well over the past three years, and so did the Stoxx index of 600 largest European multinationals, which are mostly based in Germany, France and other Northern countries.

Then there is Wall Street. Despite a decidedly lackluster economic recovery, high unemployment and a depressed real estate market, the Dow Jones Industrial Average rose to nearly 14,000 in October 2012, coming within striking distance of its 2008 all-time high. The technology-heavy NASDAQ Composite index surpassed 3,000 at the same time and traded at its highest level since the dot-com bubble burst in March 2000.

Only after the Nov. 6 presidential election did investors become sufficiently worried about the so-called fiscal cliff—the automatic spending cuts and tax increases at the start of 2013—to head for the exits.

Lack of Conviction

On balance, Wall Street has performed well. It gained 40% between mid-2010 and October 2014, and even after the October-November correction its level was twice that of early 2009. Investors and savers have seen their battered holdings of mutual funds, pensions and college savings rebound, once again indicating that stocks—especially blue chips—are safe investments. 

Nevertheless, the past three years have been a negative for long-term stock investment. Extremely sharp corrections, which come with unerring regularity and feature a 1,000-2,000 point drop in the Dow, heighten risk, as measured by volatility. Such fluctuations make a mockery of the “safety” of America’s blue chips.

These problems will persist going forward. The euro-zone crisis has not been resolved. German Chancellor Angela Merkel has admitted that it will last another five years. Since there is no blueprint for resolving the situation, her timeframe seems arbitrary—just another example of a politician kicking a can down the road.

America’s own fiscal problems are also here to stay. Even if the fiscal cliff happens—meaning that the Bush-era tax cuts are allowed to expire and government spending is slashed across the board—the Congressional Budget Office estimates that the budget deficit for fiscal 2013 would remain at $641 billion, and $400 billion a year later if a new recession can be avoided. A milder compromise between the White House and Congress will keep the deficit at unsustainable levels of around $600-800 billion annually.

A Stock Rally?

To be sure, there are reasons for optimism in 2013. A BofA-Merrill Lynch survey of fund managers found in November that a major shift was underway from bonds to stocks. That could be a huge boon for equity prices the world over. Except for euro-zone debtors, bond yields have been extremely low, both in nominal terms and in terms of spreads over record-low yields on U.S. Treasuries. Bond yields have little room to decline further, whereas the downside risk is substantial, and a flight from bonds and into stocks could become massive. 

At the same time, an increasing number of U.S. companies are now boosting their dividend payouts. In 2012, as much as $300 billion will have been paid out. Announcements of higher dividends from blue chips and run-of-the-mill companies have been coming at a rate of around 25 per week in mid-November. This, too, could become a groundswell, as companies are sitting on a record amount of cash; the stock market’s dividend payout ratio stood at less than 30% in early 2012, compared to a historic average of around 50%.

But that’s more the symptom of the underlying problem bedeviling stock investment rather than part of the solution. When an investor buys a share of a company, it is in the hope of future growth, which is achieved by the company investing in its business. But interest rates are at zero—and the U.S. Federal Reserve has indicated that it won’t raise them for another two years. A New York Fed survey found in mid-November that dealers expected the Fed funds rate to average 2.88% in the second half of 2016. This suggests that demand for borrowed funds will remain tepid.

Plus, the existence of a cash hoard suggests that, with record profits rolling in, businesses are in no mood to invest their own money, either. True, the uncertainties surrounding the fiscal cliff and the prospects of future tax increases have kept some investment decisions at bay during 2012, but cash holdings have been accumulating for many years. At $1.5 trillion for S&P 500 companies, cash on corporate balance sheets presages a future trend of weak investment and limited growth.

U.S. stocks may not reflect this, but Chinese markets surely do. The Shanghai Composite index rebounded along with the Chinese economy in 2009, but once the Chinese recovery took hold, it began a prolonged descent. In November 2012, it touched 2,000, renewing the lows not seen since the height of the global financial crisis in 2008. There are a number of other factors depressing Chinese shares, but China remains the engine of global economic growth and industrial investment, and the fact that Chinese investors are shunning their own companies is not a good sign.

At the same time, the uneven pace of the global recovery provides a number of opportunities. True, the broad S&P 500 index has not moved over the course of a dozen years, trading around where it was during the 2000 election. But some industries have emerged and become mature during this time, and a large number of companies—such as Apple, Google, Amazon and Priceline, among others—have become market leaders, making investors billions.

Technological progress is not over by any means, and other industries—notably biotech, bio-pharma, synthetic biology and energy-related technologies—are poised to lead the stock market going forward. Moreover, the emergence of exchange-traded funds allows investors to pinpoint growth industries and sectors without taking on the excessive risk of backing individual companies. 

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