SCHWABEN CAPITAL GROUP NEWSLETTER


 

To my dear clients and friends,                                                                            July 28, 2011

Equity markets have experienced significant volatility over the past several weeks. US equities are now off 4.3% for the year. The main causes for the volatility were primarily:

1.)  Arab spring and political uncertainty surrounding the consequences

2.)  Fears of slow down in the Chinese economy

3.)  Uncertain earnings seasons

4.)  Fear of the US slipping back into a recession

5.)  European debt crisis

6.)  Lastly but certainly not least the impasse in the US debt ceiling negotiations.

All these reasons are very valid reasons for concern that have stunned the appreciation of stock prices however have only had a short term impact on the fundamentals.

North American equity earnings have grown significantly in 2011. More than 70% of companies reporting have outpaced expectations in the US and more than 50% in Canada. The Dow Jones industrials Index and the S&P500 index are off 4.3% and 4.7% respectively for the year and the TSX is down 2.8% since January 1, 2011. This implies significantly lower valuation levels. The lower valuation level is caused by what is referred to a higher equity risk premium, which anticipates a lower growth rate for the economy and earnings. The above factors can certainly have an impact in the economic future of North America however in my opinion the equity risk premium at this stage is unjustified. I am listing the above uncertainties and the outcomes or consequences to this point in order to show how much less the factors have impacted economic growth and activity and North American earnings for stocks.

1.) Arab Spring – The major concern started with Tunesia and escalated with Egypt. Fear caused major disruptions in equity markets. Outcome – Mubarak conceded in Egypt and the middle east became a much lesser concern. Equity markets recovered.
2.) Fears of Chinese slow down – fears of an economic slow-down in China would spill over to the US While an economic slow down in China will impact the US economy and US earnings. An economic slow down in China is considered 9.5% instead of 9.8% or 10%. Even if the Chinese economy would slow to 7% if would be hardly anything to worry about for North America. More under the following link: http://www.chinadaily.com.cn/usa/business/2011-07/25/content_12973947.htm
3.) Uncertainty of earnings of North American equities. Companies are releasing earnings that even after last years spike in earnings offer higher than analyst expected earnings. The vast majority of US company earning (%%%)releases for the last quarter had higher earnings
4.) Fear of the US slipping back into a recession -Several indicators have indicated that the US has slowed down in certain areas of the economy. Job creation and related factors of the US have pointed to a slower recovery than many had anticipated or hoped. Job creation is a lagging indicator in an economy as companies need to increase revenues and profits before hiring new employees. Equities create profits and appreciate significantly before the economy experiences a job recovery.
5.)  European debt crisis – Greece, Portugal, Ireland, Italy and Spain (PIIGS countries) have all suffered significant economic re-adjustments. Greece’s every more potential default has raised concerns about major economic implications in Europe. Greece’s default has become an accepted term in capital markets. It has become clear that Greece’s default will be managed by the IMF and it’s member countries. No catastrophic calamity appears to happen however the equity risk premium has increased due to this event. Also Italy has shown significant signs of weakness however all these factors appear to have become less catastrophic in many investors minds.
6.) Impasse in the US debt ceiling negotiations – since last week the deficit standoff has become more extreme on political front. The chances of a default and/or a downgrade of US debt form the highest rated credit has become a greater possibility with every passing day. While the extreme right wing has taken a hard line stance. Many moderate republicans have accepted certain concessions – initially with the Gang of 6 that included republicans and democrats that were the first steps to a solution. Opinions of the consequences of a US default range from cataclysmic to no impact at all. A default would certainly have a negative impact in capital markets and most likely in the credit rating. The increasing likelihood of the possibility has been priced into equity markets over the past several days. A somewhat colourful however intriguing analysis on Marketwatch has made some excellent points and is worth reading:http://www.marketwatch.com/story/10-craziest-things-about-the-debt-ceiling-crisis-2011-07-25?Link=obinsiteA further analysis by us is included below.

 

Analysis

After reviewing the two proposals I feel that a solution by next week could be very likely. I think it would be quite conceivable that if a deal is reached before next Tuesday and US treasury bonds will not be downgraded that both the TSX and the Dow could appreciate by 500 to 1,000 points within a few days if not quicker. According to this illustration both sides are close on their fundamental bases. S&P has made it quite clear that even with a two stage deal US Treasury bonds would most likely be downgraded. Both cases,  1.) no deal gets done or 2.) a two stage debt ceiling increase would likely cause a downgrade of the US and would in my opinion be political suicide for the republicans after a downgrade. I believe that the options for republican negotiations have now become limited without the blame of the consequent turmoil being carried by the republicans.

We have not increased any of our equity exposure since the impasse become more prominent however I feel exiting equities at this point could have very regrettable consequences if and when a deal gets done. Failure of the debt ceiling being raised would definitely have a negative impact on equities and US interest rates however I do not believe in a catastrophic proportion.  It would created a creates disruption the US bond market as it could have sever implication on funds that only can hold AAA bonds.

 

The CBO verdict

How the Congressional Budget Office scored the two deficit-reduction plans by House Speaker John Boehner and Senate Majority Leader Harry Reid

BOEHNER* REID
Reduces deficit by $915 billion over 10 years Reduces deficit by $2.2 trillion over 10 years
Discretionary funding caps starting at $1.04 trillion and rising to $1.23 trillion/year Discretionary funding caps starting at $1.05 trillion and rising to $1.23 trillion/year
Establish procedures to consider balanced budget amendment More spectrum licenses, agricultural producer payment cuts
Pell Grant, student loan program changes Pell Grant, student loan program changes
Lifts debt ceiling by up to $2.5 trillion in stages Lifts debt ceiling by $2.7 trillion
Creates joint committee for more deficit reduction Creates joint committee for more deficit reduction

* – Revised plan