Volatility Continues: Are the Markets Overreacting?
Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.,
Brad Sorensen, CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research, and
Michelle Gibley, CFA, Senior Market Analyst, Schwab Center for Financial Research
Updated August 22, 2011
Key points
- Selling pressure has been heavy as European banking fears combined with soft economic data. Risks have grown, but not all is in the negative column and markets may be overreacting.
- Interest rates are near record lows, indicating to us a growing concern about growth and a search for safety.
- Investing can be nerve-wracking in environments such as this, but we believe sticking with a well-devised long-term plan continues to be the best course of action.
Confidence in Europe still shaky
Continued concerns over the debt crisis in Europe coupled with renewed worries about the stability of European banks have been inspiring investors to sell now and ask questions later.
In our opinion, what we're witnessing in Europe is the inability of policymakers to stem uncertainty, fueling a contagious illness that feeds through to vulnerable banks and countries in a "whack-a-mole" fashion. The mere possibility of a problem—something that could be possible, even if it is not probable—becomes a target. European banks are highly reliant on short-term funding, which is only exacerbating the situation, in our view.
It seems unfathomable that European policymakers have not learned the lessons of past crises, but in our opinion, they seem to be in denial about the role of confidence in financial systems. Instead of taking the opportunity to calm nerves in their recent "emergency meeting," German Chancellor Angela Merkel and French President Nicolas Sarkozy likely only added to uncertainties by raising the possibility of a new financial transactions tax, while downplaying the need to expand the European Financial Stability Facility (EFSF) that the market seems to be calling for and pushing off the possibility of common Eurobonds until sometime in the future.
What's the medicine for this illness?
To stem this crisis of confidence, we reiterate what we've been saying for some time: We believe large amounts of capital must be made available to give markets confidence that any potential problem can be addressed, regardless if it's a problem with a bank or a country. Similar to former US Treasury Secretary Hank Paulson's "bazooka," we believe the EFSF needs to be expanded multiple times over, and likely needs to come with the guarantee that private-sector investors will not face losses on their debt investments in banks. This may give investors the confidence that's now likely sorely lacking, to lend to banks and enable banks to raise their capital ratios.
Will a European "fix" be a buying opportunity in Europe?
A significantly larger-sized and more comprehensive solution to address government debt-related issues and injection of capital into banks could result in a rebound for European stocks, but we believe that longer-term issues will likely continue to weigh on growth in the "Club Med" nations of Portugal, Italy, Greece and Spain. Additionally, the severe government spending cuts in the United Kingdom will likely keep a lid on near-term growth in that nation.
Our current outlook is that global growth is slowing, and therefore (within the context of a diversified portfolio), we prefer an emphasis on Switzerland's more defensive market at this time, while looking to shift to Germany longer term, when there are better indications that global growth will reaccelerate.
Back in the United States
Early pressure from concerns overseas was quickly accelerated by the Philadelphia Fed Index dropping to -30.7, its lowest level since March 2009. At this point, we believe that the recent selling may overestimate the possibility of a recession, and we urge investors not to get caught up in the fear.
It's also important to distinguish between the economy and the market. Ned Davis Research points out that the Philly Index has never been this low without the economy being in, or about to enter, a recession, though we would also point out that it's only a regional survey and was taken during the height of the US debt-crisis debate.
However, SentimenTrader looked at the market's reaction following a reading below 30 and notes that the median gain in the S&P 500 in the year following is 22.9%—a gain four times greater than any random period of the same length—and has posted positive returns in the year following in every instance but one.
Also lending credence to the "panic is not a strategy" argument, although consumer confidence remains low at 59.5, the contrarian nature of the market is illustrated by the Dow Jones Industrial Average gaining an average of 14.4% annually when confidence is less than 66, more than double the average gain when the reading is above that number. Of course, past performance is no guarantee of future results.
What now?
We don't pretend to know what's coming for the markets in the next couple of days or weeks, as heightened sensitivity could result in continued volatility—in both directions. We continue to believe we'll avoid a recession due to continued positive leading economic indicators, an improving jobs picture, solid corporate balance sheets and a still-steep yield curve.
We're encouraged that we're seeing some nascent signs of confidence on the corporate side as demand for loans has increased and stock buybacks are at their highest level since October 2008, according to Birinyi Associates. We continue to urge investors to keep their long-term goals in mind, match their portfolios to their risk tolerance, and remind them that trying to time the market, in our experience, tends to be a losing game.
Important Disclosures
Past performance is no guarantee of future results.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
