It’s been a wild week for stocks. Not only are stocks down roughly 9% from the end of July as of the close of market August 11, but the pathway down has been marked by extreme volatility. This month we have experienced six of the 200 most volatile days of the past 50 years. We have had daily losses of 2.5 – 6.6% and have had daily gains of greater than 4.5%. These losses were kick started with the political wrangling of the debt ceiling, and were intensified with the ensuingU.S.debt rating downgrade by S&P. The market losses and volatility are leaving many investors uncertain about the state of the economy and their portfolios. We offer three scenarios to consider – base-case, worst-case and best-case – and their potential effects on the stock market.
The base-case scenario is the one that we consider most probable, and that is continued slow-growth in the near-term, with eventual normal growth resuming in the long-term. We’ve seen two quarters of slow growth already, 0.4% for the first quarter of 2011 and 1.3% growth in the second quarter of 2011. Slow growth quarters are historically not useful predictors of recessions. Given our fragile economy, such slowing may induce the Federal Reserve to engage in more economic-stimulating measures. We recognize that an offset to these growth stimulators are high, though slightly improving, unemployment, as well as global political and fiscal uncertainty.
Despite a slow-growth economy, corporate earnings are at an all time high, with expectations that S&P 500 earnings this year will be $100 per share. This puts the stock market at about an 11.5 price-to-earnings ratio, far below its historical average of 15. For this reason, we don’t see a catalyst for a further, significant, sustained drop in stocks.
The worst-case scenario is another recession. Reasons for this possibility are well known: tax uncertainty, high unemployment, nervous consumers. General panic is not known to cause recessions, though some fear this could become a self-fulfilling prophecy. Panic does indeed affect stocks however, which is what we are seeing currently. Stocks are known to be a leading indicator of recessions. When recessions do occur, the median historical market peak is about 7 months prior to the start of the recession. But typically once you know you’re in a recession, it’s actually time to buy stocks. In fact, the recessions of 1953 and 1990 saw stocks go straight up.
The best-case scenario is the resumption of robust growth. The record corporate earnings may spur business and investor confidence. There is said to be pent-up consumer demand waiting to be unleashed at the suggestion that theU.S.is still on the road to recovery. Too, oil prices have come down considerably. You may recall that just a few months ago high oil prices were a huge concern for the economy, as this necessary product would hamper other consumer spending. And though theU.S.debt downgrade has spooked the stock market,U.S.treasuries, the very debt that was downgraded, have actually rallied. This is because, in the end, investors still believe in the strength of theUnited States.
Our Chief Economist, Jim Smith, predicts year-over-year GDP growth of 1.9% for 2011 and 3.9% for 2012. Whatever the economic outcome over the next few months, we must accept that our economy is a cyclical one, in which we experience recessions and expansions. Long-term growth of GDP and corporate earnings leads to long-term appreciation of stocks. Being a buyer and holder of equities gives you the ability to participate in this long-term growth.
We believe that to be a successful investor in stocks you have to accept the volatility, and the uncertainty that surrounds it. Corrections and bear markets are part of the territory. As an investor, it’s tempting to believe that you have the ability to guess the timing and direction of stocks, but attempting to do so is hazardous to your financial health.
Harli L. Palme, CFP®