Friday, July 13, 2012

A Perspective of Value

The stock market works primarily on the idea that equities and fixed income securities have value. As the perspective of value changes the pricing of each of these two types of securities changes. Recently Spain has been under a great deal of pressure because the perception is that their banking system and economy are in poor shape and are more risky than what they were before. With this in mind you can understand why the interest rates on Spanish bonds has increased dramatically. Early this morning Italy was downgraded by two levels with a statement indicating it could be downgraded more in the future. This undoubtedly will have a negative impact on Italian bonds in today’s market, especially as the government there is doing a major refinancing of debt. In the U.S. the Federal Reserve (FED) has been holding short term rates at about zero and 10 year Treasury rates at all time lows, as of this writing 1.479%. The FED is doing this in the hopes that it will stimulate the economy, particularly the housing market. Thus, we have seen the lowest mortgage rates in 70 years. All of this points to the real problem. Worldwide economic growth is stalled. This in turn has lead to very high unemployment worldwide. This decline has been going on for some time. In October of 2007 the S&P 500 reached a new high of 1549.38. By February of 2009 it was down to 735.09 a staggering drop of 814 points or 53%! A bear market is one where the drop is 20% or more. This one was a duzy! During the recovery over the next three plus years the S&P reached 1419.04 on April 2, 2012. This was still 8% below the high in 2007. Since then with fits and starts the S&P has drifted down and is currently about 6% below the high of April. As we wait to see what earnings will be for the second quarter of this year it appears that the economy grew at a lack luster pace and that earnings for companies will likely follow with less than original estimated earnings. This is likely not to have a positive impact on stocks. The worries about equities is likely to continue to have a positive impact on higher quality bonds, especially U.S. government and corporate bonds. Historically the market goes up before a Presidential election and this may be the case this year. Looking at the fundamentals of the economy and the long term trend in the supply and demand for stocks I think this will remain a hard period for stocks to show significant gains and more likely trend down. My guess is that we may have entered the beginning of a bear market on April 2nd and are now going thru the stages of reaching a bottom. If that is the case then we could see the stock market lose about another 14% from where we are currently. Ed Mallon