Second Quarter Update

After another three months of volatility, the major market averages didn’t move much in the second quarter, ending right about the same levels as the end of March.  If it weren't for the last three days of the quarter, the markets would have been down a few percent.  The Dow Jones Industrial Average declined (0.77%) for the quarter; the Nasdaq Composite declined (0.27%); the Russell 3000 Index was unchanged; and the S&P 500 declined (0.39%), excluding dividends.  International markets, as measured by the MSCI EAFE Index, actually rose 1.83% during the quarter.  The Barclays Capital Aggregate Bond Index was the big standout, increasing 2.29% during the quarter.   

While the news over the past several weeks has been fairly negative, the one thing missing from the constant cascade of worrying headlines is any hint of deterioration in US corporate earnings, outside of the financial sector which has a separate set of problems.  This doesn’t insulate the US stock market from the possibility of increased volatility in in the short term in reaction to news, but the overall recovery is likely to remain positive.  So far this month most earnings reports have come in a bit better than expectations, which is a good sign.

Earnings estimates have remained steady over the past several weeks.  As of July 1, 2011, earnings estimates were $98.39 for the year ending in December, an increase over the $97.00 estimates as of April 1, 2011.  Economists and analysts are currently posting estimates of $111.00 for 2012, a 13% increase over the current 2011 estimate, and probably consistent with 2 - 3% overall economic growth.

The Debt Ceiling - A historical look back

The current debt ceiling battle is the topic du jour in Washington.  The Republicans, influenced by the Tea Party, argue that simply raising the debt ceiling over and over again is an unsustainable policy, so they're insisting on budget cuts or no deal will get done.  Many Democrats agree that the U.S. has a deficit problem, but they stress the necessity of raising the debt ceiling promptly in order to prevent default or problems funding other U.S. obligations. With all this arguing about “to raise or not to raise” we thought it might be informative to take a look at the past.

The debt ceiling was first set in September 1917. At that time, Congress authorized the issuance of about $7.5 billion in U.S. bonds and another $4 billion in certificates of indebtedness, under the Second Liberty Bond Act.  How much was $11.5 billion dollars back then adjusted for inflation?  In March 2011 dollars, it would be roughly $193 billion. Currently, the debt limit is set at $14.3 trillion -- so inflation doesn't tell the whole story! To be sure, Washington's love affair with debt has grown tremendously over the past 25 years.

So first, here's the debt limit throughout history, charted along with actual U.S. debt outstanding:

The chart shows that the debt ceiling (thick red line) didn't even hit $1 trillion until 1982 -- less than 30 years ago. Since then, it's increased exponentially. Of course actual debt outstanding (thin green line) moves right in sync with the actual debt ceiling, as it generally only rises when the government decides to issue more debt.

You can see the ceiling is a sort of step function, as it increases based on Washington's whims, not a natural mechanism. This chart also shows that increases in the debt ceiling are quite common. Over the 94-year period, the debt ceiling has been revised 102 times.

Depending how high Congress raises the ceiling in coming months, it could potentially surpass 100% of our nation’s GDP.  It would take at least a $700 billion increase: currently the ceiling is set at $14.3 trillion and would have to be a little greater than $15 trillion to move past the annualized GDP estimate. The last time Congress raised the debt ceiling, in February 2010, it increased the limit by almost $2 trillion.

In the end, a decision comes down to a determination of whether the potential harm of the budgetary cuts necessary to avoid raising the ceiling are worth the risk they pose to the U.S. economic recovery.  But history does help show that longer-term fiscal reform is needed to cure Congress of its addiction to debt.

"Twinkie Market"

In an interview with Jason Zweig at the end of last year, Seth Klarman, a legendary Boston-based hedge fund manager known for his astute investment management skills, called this "a Twinkie market." He went on to say that “It is fun and tasty, but all the ingredients are artificial.” We would add that Twinkies aren't really good for you either. We believe this analogy rings even more true today than it did at the end of 2010.  The simple truth is that by holding interest rates at an effective 0% level, the Federal Reserve has executed a forced asset allocation liquidity trade. To earn a return on your cash and keep pace with inflation an investor has to increase his/her risk levels by moving into riskier assets. Money that was in savings accounts or other fixed-rate investments like CD’s, has found its way to the stock market or other investments looking for some rate of return.  

Mr. Klarman went on to say that he was more worried about the world than he had ever been in his career. He stated that the global and domestic risks keep increasing with each passing month. European sovereign debt is the most obvious problem as it has dominated the recent headlines. Europe is trying to “kick the can down the road” with the current Greek situation, but other countries, including Italy, Portugal and Spain, also face potential debt problems. In recent weeks, we have seen the protests in Greece on television, and perhaps we will see them repeated in other nations as they must face difficult choices to deal with their own financial conditions.

Here at home, the risks include political posturing surrounding the debt ceiling for the federal government and severe funding problems for many state and local governments.  We recently read an article about the U.S. needing to take its own austerity measures at some point in the future.  We believe this is entirely possible in the years ahead.

So with a renowned hedge fund manager worried, the prospect of a further debt crisis in Europe, and debt issues here in the U.S., shouldn’t the global markets be reacting to this bad news and moving significantly lower?  The simple answer is yes.  But the reality is that these concerns/issues don’t matter until they do matter. As long as the current problems don’t prevent companies from increasing revenues and earnings (which hasn’t happened yet) the problems don’t matter.  At some point they probably will matter, but at the moment they don’t.   

This doesn’t mean one should totally disregard the news entirely because understanding the macro economic trends are important; but the global markets, while subject to news-based volatility, will tend to follow the underlying trend of economic activity and earnings rather than the headline news.  And so far the trend of economic activity and earnings has been positive, albeit at a slow rate.

Widgets for the Weekend

Happy Fourth of July!  Please enjoy the weekend -

With all of the talk of austerity in Greece (and other European countries), congress dealing with our own debt ceiling limit, and the grumblings about the high price of gas, we want to share some interesting widgets we found.  The data updates in real-time (or close to it).  The numbers speak for themselves!