Market Comments - May 21, 2010
Since the end of the first quarter, the S&P 500 Index
has fallen by roughly 10%, putting it into what some market commentators call a
“correction.” (Of course, the market is up over 50% from its March 2009 lows despite this.) The well-known issues in Europe are
reminding global investors that sovereign credit risk is very real. That is, governments around the world have
debt problems and Greece’s issues may be a microcosm of what might be to come
in countries such as the United Kingdom and even the United States.
Here is what we know: Greece is in trouble and would default
without outside intervention. The
country has been in default more than half the time since its independence in
1829, so this shouldn’t come as a shock.
The time for surprise should have come at the beginning, when they were
allowed into the 16-country European Monetary Union (countries that use the
euro as their common currency). Now,
there is no pre-determined procedure to remove them so the European Central Bank
has done something it said it would not do – bail out countries that can’t make
it on their own. In the process it is
bolstering moral hazard and stoking the coals of future inflation (despite their
assertions to the contrary). To use a
baseball analogy, Greece is currently up to bat and countries such as Spain,
Ireland, Italy, and Portugal are “on deck” for assistance. But in the dugout are countries around the
world – those with massive borrowing needs in the years ahead as implied by unsustainable fiscal and trade deficits.
Increasing credit risk - the risk that a borrower will default or need to restructure its debts - tends to lead to a higher cost of borrowing. Since corporate and household interest rates are priced based on the rates at which their government borrows, this leads to concerns about future economic growth. These fears are not unfounded. But it is clear from this “flight to quality” that the United States is still considered a safe harbor or, as we like to say, the tallest of the seven dwarves. This keeps our borrowing costs down when perceived risk is elevated.
What
does this mean for the markets? We
believe stocks remain fairly valued despite the 10% price drop. Some consider this fall as correcting what
was budding overvaluation. For
perspective, based on the past 100 years the broad market is
at the 70th percentile; this means that only 30% of the time have
prices been higher than they are today relative to earnings. Subsequent returns from lofty starting valuations levels tend to be lower on average. Valuation, however, does not tell the whole
story in terms of what markets will do.
Greater volatility and heightened risk aversion imply falling prices in
the near term but the trend can reverse quickly. It certainly did in March 2009.
-- The Clarity Asset Management Team
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