by Bob Doll, Chief Equity Strate­gist, Black­rock, Inc.

Novem­ber 28, 2011

A Sharp Drop for Stocks

Equity mar­kets sank sharply last week as the Euro­pean debt cri­sis wors­ened and the US super com­mit­tee failed to come to an agree­ment. For the week, the Dow Jones Indus­trial Aver­age fell 4.8% to 11,231, the S&P 500 Index dropped 4.7% to 1,158 and the Nas­daq Com­pos­ite sank 5.1% to 2,441. Because the polit­i­cal prob­lems in the United States and the cri­sis in Europe could result in a nearly end­less array of out­comes, investors are faced with a high degree of uncer­tainty. As a result, unless and until more clar­ity emerges, mar­kets are likely to remain some­what trend­less in the near term.

Out­look Uncer­tain for the Euro­pean Debt Crisis

While much of the focus on the euro cri­sis has been on Greece and its risk of default­ing, in recent weeks, that focus has shifted to a gen­eral lack of liq­uid­ity within the Euro­pean debt mar­kets as banks strug­gle to main­tain credit rat­ings. Many large global banks are attempt­ing to sell or reduce their expo­sures to trou­bled Euro­pean sov­er­eign debt, and the sell­ing pres­sures are trig­ger­ing a new surge in gov­ern­ment bond inter­est rates. This, in turn, has been forc­ing more coun­tries into higher debt bur­dens and big­ger deficits.

At this point, it has become clear that the mea­sures taken so far to stem the cri­sis have not been suf­fi­cient. In our view, it will prob­a­bly require the cre­ation of some­thing like a com­monly issued euro bond to con­tain the debt cri­sis. Although Ger­many has so far resisted that pos­si­bil­ity, there are grow­ing indi­ca­tions that such a solu­tion may well be forthcoming.

Regard­less of what hap­pens in the debt cri­sis itself, a reces­sion in Europe now seems a fore­gone con­clu­sion. Should pol­i­cy­mak­ers be able to come to an effec­tive res­o­lu­tion soon, the reces­sion is likely to be shal­low, but risks are grow­ing that the reces­sion could be deeper. It is an open ques­tion as to how much a Euro­pean reces­sion would impact the United States and other global mar­kets. The main risk comes in the form of the inter­twined nature of the global credit mar­kets since severe Euro­pean bank delever­ag­ing could neg­a­tively impact US credit avail­abil­ity as well.

Super Com­mit­tee Fail­ure Cre­ates a Murky Debt Future

The fail­ure of the super com­mit­tee to pro­vide a plan to reduce the deficit was cer­tainly dis­ap­point­ing, but it would be a mis­take to put too much stock in that spe­cific inci­dent. The dead­line imposed by Con­gress was an arbi­trary one and the auto­matic cuts set to take place as a result of the non-decision will not occur until Jan­u­ary 2013. As a result, Con­gress still has an oppor­tu­nity to address deficit reduc­tion, but of course the fact that all of this is occur­ring with the back­drop of the 2012 elec­tions means that uncer­tainty lev­els are elevated.

In our view, the more impor­tant ques­tion is whether or not Con­gress will be able to extend the pay­roll tax cuts and unem­ploy­ment ben­e­fits set to expire at the end of this year. Should they be unsuc­cess­ful in doing so, it would likely cre­ate a sig­nif­i­cant fis­cal head­wind in 2012.

Stocks Likely to Remain Range-Bound

Some­what lost amid all of the euro debt and US polit­i­cal head­lines has been the fact that US eco­nomic data has con­tin­ued a grad­ual improve­ment. The Novem­ber pay­rolls report is set to be released this Fri­day and indi­ca­tions are that it will be decent. True, last week it was reported that third-quarter gross domes­tic prod­uct (GDP) growth was revised lower, but the inven­tory reduc­tion that occurred may help set the stage for a stronger fourth quar­ter. At this point, fourth-quarter GDP looks to come in at 3% or pos­si­bly higher based on improved prof­its, a bet­ter labor mar­ket, increased cap­i­tal expen­di­tures and a low cycli­cal start­ing point for inventories.

Eco­nomic accel­er­a­tion should cre­ate firmer foot­ing for stocks, but for the time being, we believe mar­kets will remain focused on the short-term head­lines. Of all of the fac­tors affect­ing the mar­kets (US pol­i­tics, the eco­nomic slow­down in China, etc.) the most crit­i­cal remains the Euro­pean debt cri­sis. Stocks are likely to remain range bound (trad­ing between the 1,100 and 1,250 level for the S&P 500) for now, but should pol­i­cy­mak­ers be suc­cess­ful in gain­ing some trac­tion, mar­kets could see some bet­ter results.

About Bob Doll

Bob Doll is Chief Equity Strate­gist for Fun­da­men­tal Equi­ties at Black­Rock^® a pre­mier provider of global invest­ment man­age­ment, risk man­age­ment and advi­sory ser­vices. Mr. Doll is also Lead Port­fo­lio Man­ager of BlackRock's Large Cap Series Funds. Prior to join­ing the firm, Mr. Doll was Pres­i­dent and Chief Invest­ment Offi­cer at Mer­rill Lynch Invest­ment Managers.

Sources: Black­Rock, Bank Credit Ana­lyst. This mate­r­ial is not intended to be relied upon as a fore­cast, research or invest­ment advice, and is not a rec­om­men­da­tion, offer or solic­i­ta­tion to buy or sell any secu­ri­ties or to adopt any invest­ment strat­egy. The opin­ions expressed are as of Novem­ber 28, 2011, and may change as sub­se­quent con­di­tions vary. The infor­ma­tion and opin­ions con­tained in this mate­r­ial are derived from pro­pri­etary and non­pro­pri­etary sources deemed by Black­Rock to be reli­able, are not nec­es­sar­ily all-inclusive and are not guar­an­teed as to accu­racy. Past per­for­mance is no guar­an­tee of future results. There is no guar­an­tee that any fore­casts made will come to pass. Reliance upon infor­ma­tion in this mate­r­ial is at the sole dis­cre­tion of the reader. Invest­ment involves risks. Inter­na­tional invest­ing involves addi­tional risks, includ­ing risks related to for­eign cur­rency, lim­ited liq­uid­ity, less gov­ern­ment reg­u­la­tion and the pos­si­bil­ity of sub­stan­tial volatil­ity due to adverse polit­i­cal, eco­nomic or other devel­op­ments. The two main risks related to fixed income invest­ing are inter­est rate risk and credit risk. Typ­i­cally, when inter­est rates rise, there is a cor­re­spond­ing decline in the mar­ket value of bonds. Credit risk refers to the pos­si­bil­ity that the issuer of the bond will not be able to make prin­ci­pal and inter­est pay­ments. Index per­for­mance is shown for illus­tra­tive pur­poses only. You can­not invest directly in an index.

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