Newsletters 2010 Newsletters Dissecting the Correction
Friday, 12 February 2010 18:09
After an initial two-week surge to start the year, the stock market hit a short-term peak on January 19th and has been in correction mode ever since. For the month of January, the S&P 500 Composite, Dow Jones Industrial Average and NASDAQ Composite fell -3.70%, -3.46% and -5.37% respectively. By the time next month’s newsletter is published, it appears very likely that the stock market will have undergone its first correction of at least 10% since this bull market recovery began in March of 2009.
After such a strong rally, over 70% since the lows of last March, we are not surprised that the market is undergoing a normal, healthy correction. We are, however, somewhat surprised by its timing. After all, the historic election of Republican Scott Brown in Massachusetts, filling the vacant seat left by the late Senator Ted Kennedy, was supposed to have brought gridlock back to Washington. And that was supposed to be good for the market, right? As we embarked on the New Year, our primary concern was the growing risk of policy error that may result from the unprecedented expansion of big government under the Obama Administration. While Scott Brown’s election did go a long way to blunt President Obama’s far reaching aspirations and alleviate much of our primary concerns, the stock market has responded by “selling the news”, indicating a market advance grown tired and in need of consolidation.
Before we examine the likely catalysts for the current downward move, we are compelled to emphasize the importance of Scott Brown’s election. Not only did he win in arguably the most liberal state in the nation (only 12% of Massachusetts voters are registered Republican), he did so by a decisive 5% margin. And this 5% margin of victory, after Massachusetts voters supported Obama by a 26% margin over John McCain, signifies an incredible 31 point swing only one year to the day from President Obama’s inauguration. Brown specifically ran as the “41st Senator”, the one that would deny the Democrats their filibuster-proof majority, and consistently campaigned against health care reform and the emerging threats of big government. His victory, on the heels of other gubernatorial upsets by conservatives over liberals in Virginia and New Jersey, signifies a major movement in American politics.
After Obama narrowly beat John McCain, there was much debate as to whether the norms of our collective political continuum had undergone a secular shift away from the seemingly well entrenched “center-right”. The recent elections seem to clearly indicate that the United States remains politically quite centered and have served as an obvious referendum on President Obama’s far-left-of-center agenda. With Brown now seated, health care reform will require significant muscle (and maneuvering) to go through as previously slated. Further, it would now seem that “cap and trade” and “card check” are all but dead. Independents have spoken loudly for fiscal conservatism. Rising from the rubble of the housing bubble and subsequent credit crisis, the “tea party” movement, originally a backlash reaction to “bailout nation”, is blazing an unmistakable trail against big government and holding politicians in their wake accountable, Republicans and Democrats alike. The 2010 elections loom large and will have significant impact on how the United States ultimately unwinds its interventionist ways and “pivots” to policies that encourage hiring and stimulate growth. How ironic it would be if the movement that has now thwarted much of Obama’s big government initiatives (and will likely spell the end of office for both Harry Reid and Nancy Pelosi) also throws John McCain out of office. Indeed, the movement underway feels like an equal-opportunity insurgence against the incumbent and against the status quo.
In addition to traders having “sold the news” of the Scott Brown election, there are clear catalysts that brought fear and volatility back to the stock market:
1) China has announced specific plans to curb bank lending in order to cool down a potentially overheating economy in general and housing market in particular. Since China has been perhaps the most significant engine in the global recovery, the markets are concerned that any slowdown in China will have a ripple effect. While China’s moves may have short-term impact, we would far prefer a government-engineered soft landing in China to a U.S. style housing bubble.
2) The rising risk of sovereign debt default in Greece has the markets focused on potential contagion and the future of the euro. The relative value of the dollar has catapulted as a result of the sinking euro and brought about an unwinding of the heavily crowded “dollar carry trade”. Greece’s woes offer a stark reminder that countries cannot borrow their way to prosperity and further illustrates, despite our challenges, that the dollar continues to maintain its safe-haven status around the world.
3) Instead of moving (even a step) closer to the middle as a result of the Scott Brown “wake-up call”, President Obama doubled down on populist rhetoric and went on a full frontal attack of the banking industry, introducing a new bank tax and proposing the so-called “Volcker Rule” that would essentially separate commercial and investment banking. Not wanting to be outdone, Senators of both parties caught the populist bug, threatening to deny Ben Bernanke of a second term. In a post Scott Brown world, we believe that the President’s bark will be much louder than his bite. This rhetoric, as untimely as it may be and as unsettling to the markets in the short run, is unlikely to make its way to becoming actual law, unless in a much watered-down manner.
As concrete as these catalysts are, they do not change the facts that support our cautiously constructive view of the stock market. Interest rates remain at historic lows and subdued inflation is likely to keep rates low for an extended period, at least until employment trends improve measurably. Corporate earnings continue to surprise to the upside with approximately 75% of 4th quarter earnings topping consensus estimates. And most importantly, economic news continues to point to a recovery well underway. Consider these recent data points:
- After increasing by 7.2% in the third quarter of last year, productivity rose by 6.2% in the fourth quarter of 2009. The productivity gains of these last two quarters are stronger than at any time since the 1960s.
- January same-store retail sales rose by 3.3%, the highest monthly gain since April of 2008.
- The Conference Board’s Consumer Confidence Index jumped to 55.9, the highest level of the Index since it plummeted after the bankruptcy of Lehman Brothers in September 2008.
- The January ISM Manufacturing Index spiked higher to 58.4 from 54.9 in December, its highest level since August of 2004.
- The January ISM Services Index rose back over 50 to 50.5 from 49.8 in December. Readings for the ISM over 50 signify growth.
- Durable goods orders increased by 0.3% in December after declining by 0.4% in November.
- Factory orders grew by 1.0% in December, the same pace of growth as November.
- Pending home sales rose by 1.0% in December after falling by 16.4% in November.
- Core inflation increased by 1.8% last year, slightly below the Fed’s target level of between 2.0% and 2.5%. While inflation trends are tame, they are not deflationary as the market feared during the great panic.
- Nonfarm payrolls declined by 20,000 jobs in January and unemployment actually fell to 9.7%, its lowest level since August 2009.
- Kansas City Fed President Thomas Hoenig registered the first dissenting vote at the recent FOMC meeting, giving a boost to the dollar and indicating that at least one voice at the Federal Reserve believes the economy to be strong enough to sustain a hike in rates.
The overall market (measured by the S&P 500) now trades at 14.2 times current consensus earnings estimates for 2010 and 12.6 times consensus earnings estimates for 2011. This seems very reasonable in such a low interest rate environment, In the meantime, our focus on dividend growth should continue to reward our clients. In the last few months, core Osher Van de Voorde companies as diverse as 3M, L-3 Communications, United Technologies, CVS Caremark, Colgate Palmolive, Vodafone, Linear Technology and Abbott Labs all raised their annual dividend.
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