Perennial May Euro Crisis Hits U.S. and Global Markets
ING Investment Management
By Douglas Coté
June 5, 2012
- For the third straight year, a Euro-crisis hit markets in May
- Investors are fearful and looking for a plan of action
- A good plan should defend against bear markets but not overreact to normal volatility
- Earnings growth remains positive — the U.S. is slowly but surely moving forward
- Ample rewards await those who stay focused on long-term goals
For the third straight year a euro crisis hit markets in the month of May. This time it started with European elections and a relatively smooth change of leadership in France from Sarkozy to Hollande. But the Greek elections, held on the same day, were anything but smooth and descended toward anarchy, culminating in threats of a Greek exit from the euro or forcible expulsion at the hands of other euro zone members — a veritable Rubik’s cube dilemma.
Concurrently, Spanish banking woes were compounded by a flurry of weak economic data from the U.S. and abroad. Friday, June 1 witnessed a pummeling of United States markets into a technical correction, and global bourses were hit even harder. As uncertainty and doubt overshadow fundamentals, investors are fearful and look to their advisors for a plan of action and an explanation of the most likely outcome.
An Investment Strategy Plan
Since many investors are intent on selling now, it makes sense to evaluate the merits of a plan that distinguishes a true sell signal from a false one. A true sell protects investors from further losses, while a false sell is a lack of discipline in the face of a temporary market drop, a potentially costly response. We believe a plan should be defensive against bear markets but not overreact to normal volatility. Defense is necessary because investors fear losses twice as much as they appreciate gains — an observation attributed to behavioral theorists Kahneman and Tversky in a paper titled “Prospect Theory: An Analysis of Decision under Risk.” If investors are twice as anxious about losses, then it certainly makes sense to be on guard. No matter how fervent the commitment to an objective set of signals, it takes a strong discipline to persevere in times of duress because the temptation to lose heart is compelling. Once implemented, the same signal or set of signals should govern the timing of an exit from the defensive posture.
One effective signal is corporate earnings growth for the S&P 500 (as a proxy for the markets). Corporate earnings are the canary in the coal mine, and since about half the sales of the U.S. market are from overseas, U.S. corporate earnings also serve as a global warning sign. CEOs are paid to grow earnings, and although not all succeed, the market as a whole usually does. If the market can’t get it done, then something is seriously wrong, and it is time to take decisive defensive action, recognizing that bad markets, once firmly in place, may ripen into a trend.
Today, corporate earnings growth is clearly and unequivocally positive, despite the ugly markets we find ourselves in. First quarter earnings growth is up six percent (year-over-year), meager certainly, but three times the consensus view of analysts at the beginning of the quarter. In our view, this is not a time to capitulate; rather, it is a time to be disciplined, to be a committed investor, to ride this temporary volatility with an effectively diversified global portfolio.
The accompanying charts show that earnings growth remains very impressive. In fact, the market’s earnings level hit an all-time record high in 2011 and is fully on track to surpass it in 2012. Since 1999 the market’s price return is negative, but earnings have grown 250% — from $39 to $97 in 2011 — and are on track to reach $105 by the end of 2012. This is compelling fundamental value for the market and an extraordinarily strong platform from which to withstand a temporary market downturn — such as the one we are experiencing today.
Fixed income effectively protected a globally diversified portfolio from volatility so far in 2012
The Global Asset Allocation strategy is comprised of ten asset classes, equally weighted: S&P 500, S&P 400 Midcap, S&P 600 Smallcap, MSCI U.S. REIT, MSCI EAFE, MSCI BRIC, Barclays Capital U.S. Corporate Bonds, Barclays Capital U.S. Treasury Bonds, Barclays Capital Global Aggregate Bonds, Barclays Capital U.S. High Yield Bonds.
Since 1999 the market’s price return is negative, but earnings have grown 250% — from $39 to $97 in 2011 — and are on track to reach $105 by the end of 2012.
Advancing earnings drive markets up, and negative earnings drive markets down, albeit with a reporting lag.
Source: Standard & Poor’s, First Call, FactSet, ING Investment Management
Earnings have advanced for the eleventh consecutive quarter which bodes well for market strength to resume.
Source: Bloomberg, FactSet, Standard & Poor’s
The Global Risk Meltdown 2012
The global markets were off to the races through the first quarter, the best since 1998, and then it started to unravel.
- Spain tried to recapitalize its own banks and was summarily rejected by the European Central Bank (ECB). They need help from the European bailout fund, the Europe Stability Mechanism (ESM), but bank recapitalizations are not allowed.
- The result of Greece’s election bordered on anarchy. The hard fought agreements to put a firewall around the country’s extraordinary debts are now in serious jeopardy, adversely impacting European banks directly, but implications for banks around the world are also perilous.
- The BRIC countries are struggling for growth, and China in particular looks vulnerable to a hard landing.
- The U.S., still the economic bright spot and world leader, hit a series of weaker than expected economic data, notably an anemic non-farm payrolls report.
This was enough for investors without a plan to run for the exits and ask questions later. But for disciplined investors, it bears repeating that history favors patience and fortitude.
Fundamentals Press On Despite Global Risks
- Advancing corporate profits. Profits for Q1 2012 increased 6% over Q1 2011. Top line revenues increased 5.2%.
- Broadening manufacturing. The U.S. ISM manufacturing index expanded for the 35th month, and non U.S. manufacturers agree. Manufacturing is buttressed by higher productivity, cheap natural gas, and reduced political risk and regulatory burdens.
- Consumer strength underestimated. While the rate of consumer spending has abated, consumers still increased their spending in April to a new all time monthly high.
- Developing economies are driving global growth. Not all is doom and gloom. Turkey, Greece’s neighbor, has dazzled investors with 9% growth in 2010 and 8.5% in 2011.
The fundamental bottom line: the U.S. is slowly but surely moving forward. Perhaps the pace is not as fast as investors would like, but the U.S. is the best horse in this race.
European Resolution Scenario
A look at recent history suggests the most likely outcome for the present difficulties. The troika (ECB, EC, IMF) and the U.S. Federal Reserve showed determination and resolve by acting in concert to stave off the last crisis, and we doubt this situation will produce a different result. June will be a busy month, offering clarity to the most serious impending risk and a possible positive outcome for Europe, as well as other important background events.
- Irish voters approved the European Union (EU) fiscal compact and euro zone austerity rules as reported on June 1.
- Greece’s pro-bailout New Democracy party is ahead in the polls for the June 17 elections. A victory would resolve one of the biggest threats to the European Union.
- A European Union official declared that July 9 is the target date to kick off its permanent euro-area rescue fund, the 500 billion euro ($620 billion) European Stability Mechanism.
- Germany is not only the mainstay behind financial support for the euro — its growth rate, unemployment and business momentum kept Europe out of technical recession.
- The U.S. Federal Reserve flooded the four central banks with U.S. dollars in September and again in November to dramatic effect.
The market has experienced tremendous volatility over the past three years. Nevertheless, corporate earnings growth has been positive, suggesting a steadfast commitment to a globally diversified portfolio of risky assets. During this time investors could have earned double digit returns with less risk. Ample rewards still await disciplined investors who can look across this valley of temporary volatility and stay focused on long-term goals.
This commentary has been prepared by ING Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) interest rate levels, (4) increasing levels of loan defaults (5) changes in laws and regulations and (6) changes in the policies of governments and/or regulatory authorities.
The opinions, views and information expressed in this commentary regarding holdings are subject to change without notice. The information provided regarding holdings is not a recommendation to buy or sell any security. Fund holdings are fluid and are subject to daily change based on market conditions and other factors.
Past performance is no guarantee of future results.
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