Stock valuations on both an absolute and relative basis are increasingly attractive. Based on Standard & Poor's estimate of reported profits over the 12 months ended June 30, 2011, the price-earnings ratio as of August 8th was 13.4, 15% below the long-term average of 15.8. This translates into an earnings yield of 7.5%, far in excess of the modest 2.4% yield offered by a ten-year Treasury note.
On a sovereign debt front, the downgrade of long-term U.S. debt to 'AA+' from 'AAA' by Standard & Poor's has not had a material impact on credit markets. Importantly, the S&P reaffirmed the top rating of 'A-1+' on U.S. short-term debt. Also, the rationale behind their downgrade was the political impasse in the U.S. that thwarted a balanced solution to deficit reduction as opposed to either solvency or liquidity issues. The elections in 2012 will offer an opportunity to resolve this gridlock.
The European debt crisis is of greater concern since solvency worries concerning Italy and Spain lie at the heart of the problem. However, rising government yields as well as the market correction has triggered a speedy response. Both Italy and Spain have announced additional austerity measures as well as long overdue structural reforms which should accelerate their move to balanced budgets.
The European Central Bank (ECB) has also commenced buying Italian and Spanish government bonds with the immediate impact of reducing borrowing costs for both countries. Since the ECB is ultimately funded by the eurozone countries, this indirectly extends the support of the stronger European countries such as Germany and France to weaker nations; a vital move in reducing the probability of sovereign debt defaults and the consequent contagion.
On a monetary front, expansionary policy in the developed world has lowered short-term rates to rock bottom levels for an extended period. Even within most developing countries, recent rate increases leave policy generally accommodative for growth. Continued economic weakness is likely to lead to additional quantitative easing as well as lower interest rates in Europe. Most importantly, money supply growth in the U.S. and Europe remains solidly positive as central banks ensure that the contraction of the money supply, the hallmark of the Great Depression, is avoided.
In conclusion, the U.S. downgrade, resurgent sovereign debt concerns in Europe and a political leadership vacuum in concert with reduced economic momentum triggered a reappraisal of global growth prospects and a sharp sell-off in markets. Downside risks are certainly elevated as business and investor confidence have been shaken by the events of the past few weeks so some investors may want to trim their risk exposure. Investors with customized, diversified long-term strategies should ensure their portfolios are in line with their target asset mixes and stay on course.
August 9, 2011
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