August 9, 2011
To my valued clients and friends,
Since my last newsletter the US debt ceiling impasse has been resolve however S&P downgraded the US creditworthiness. The current equity market volatility and panic is more driven by a lack of volatility and the absence of many institutional investors over the summer months. Pension funds are long-term investors and have long term asset allocation targets that they require to maintain. As such the tactical asset allocation of pension funds is not impacted by short-term events however is more driven by relative valuations of various asset classes and not by short-term fears or panics. The past several weeks have significantly re-adjusted the relative valuations and should sooner or later revert to their normal norm. I am making significant reference in my analysis to the US and less to Canada as the current market conditions are driven to a very large extend on the events in the US. Equities in the US were not over valued even before the recent correction at 14 to 15 times for the Dow Jones Industrial index and the Standard and Poor index before the recent decline. At a P/E ratio currently of 11.6 for the Dow and 12.3 for the Standard and Poor index equities have become very cheap in the US. This does not mean that in the short term a further decline may not be possible however it is an indication that with current earning fundamentals and valuations in corporate America are very sound. Canadian equities are valued above these levels however are now at 15.9 and not considered expensive either. Equities should recover significantly over the next 6 to 12 months. In 1987 the Dow Jones Industrial Index had recovered all its losses from the decline of leading up to and including Black Monday within 6 months. This was almost a 40% decline from top to bottom. The Dow Jones in August of 1987 was above 2,700 at its height and at the bottom had reached 1,700 the year that I started in the investment business. I have a more in detailed and in-depth analysis of the recovery of the 2008 decline in the February of this year in the Schwaben Blog at http://SchwabenCapital.wordpress.com . Over the past P/E ratios for the Dow Jones and the Standard and Poor’s index have reached levels between 20 to 25 with less corporate earnings growth than this year. This reflects that although investors are nervous due to all the geopolitical events that occurred this year, corporate fundamentals are still very strong with very reasonable valuations.
Equity market volumes were significantly lower in July due to the summer season. Only in the first week of August did volume spike due to individual investor panic both on a direct investment basis and due to Mutual Fund redemptions that have forced Fund Manager to liquidate a significant amount of holdings into a market that does not have rationality. Institutional investor, especially pension funds are generally less active over the summer months as such volatility has naturally been higher than normal especially with various geopolitical factors playing a more intense role. Pension fund have so far not significantly stepped in as they are waiting for “the dust to settle”. Since our last newsletter congress has passed the bill to raise the debt limit however not until the very last minute and not without politically and economically “speculative games” in favor of attempting to obtain the upper hand in the next election. Unfortunately this has now come at the expense of the general public, retirees and many other investors. Up to this point the US economy was on the road to recovery although not as strong as expected however earnings have increased and employment numbers last week were revised upwards and employment numbers were better than expected. However since the impasse only Moody’s and Fitch had reaffirmed the “AAA” credit rating for the US. Standard and Poor’s still had not re-affirmed the “AAA” credit rating causing significant nervousness by investors. A re-affirmation would have resulted in a relieve rally in equities.
Although the US finances have significantly deteriorated during the last administration caused by the US credit crisis and military spending, The US financial position has not deteriorated to the point where it should have received a lower credit rating however the US impasse and political wrangling over the debt ceiling has exposed the risk of a dysfunctional congress in the US. The mere fact that some politicians were willing to gamble on the potential default of the US government on its debt has caused many investors to reassess the political and sovereign risk of the US. Both, Moody’s and Fitch obviously focused primarily on the financial stability and dominance on the US. Standard & Poor’s on the other hand had allocated significantly more weight to the current political instability. Given that credit rating agencies were severely criticized after the credit crisis in 2008, Standard and Poor may have reacted too soon rather than too late. While the credit downgrade by Standard and Poor’s downgrade has limited impact on investment funds at this point, the potential ramification of what would happened if a second rating down grade by either Fitch or Moody. Furthermore and the fact that the US has never had anything less than a “AAA” and the fact that Standard and Poor was aware of the political backlash it would receive after the downgrade speaks volumes about Standard and Poor’s decision. Japan had lost its “AAA” credit rating in 1991 and did not regain it until 1999. Most funds that are mandated to only invest in “AAA” require that at least 2 out of the 3 credit rating agencies must have a “AAA” credit rating on the investments. Furthermore the US debt represents 75% of the total debt globally as such the two largest creditors, China being number 1 and Japan being as number 2, have limited options to invest in other major liquid bond markets. Although S&P had downgraded the US to “AA+”, the second highest credit rating, Japan had re-affirmed that it considered US bonds as the safest investment, while China on the other hand had handed out significant criticism on the US’s handling of their finances.
As of this morning overseas equity markets have erased losses and US index futures over night have gone through drastic volatility from the Dow futures were down over 300 and later on rallied to 350 points into positive territory. This represents more than a 6% swing of the index. As of 7:23 this morning S&P index futures are up 2.3% – recovering a significant portion of yesterday’s losses.
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