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 November 2011 Snatched from the Headlines Move over ECB, here comes the "Super Committee"
After the best start for the Dow in the past twelve years, the third quarter more than wiped out the spring's double-digit gains leaving all major equity indexes down for the year. Shell-shocked investors fled stocks and sought the safety of U.S. government securities. This increased demand sent bond prices up as their yields, which move in the opposite direction, melted away. S&P's August cut to the country's credit rating obviously had little lasting effect. Investors who did remain in stocks favored larger company shares over their smaller counterparts. When the third quarter ended, the Dow Jones was off 5.7% for the year, while the S&P 500 was down 10.0%, and the small cap stocks of the Russell 2000 were just short of a 20% bear market loss. This wasn't just a U.S. phenomenon; in fact, domestic investors fared better than those dabbling in foreign stocks or shares of emerging economies. As long as large developed economies teeter on the edge of recession, smaller developing economies have less opportunity to sell their natural resources and cheap labor. Nevertheless, October was once again the turning point. After just one day of trading, stocks were ready to stage a month-long recovery. On October 3, the Dow Industrials, S&P 500, S&P 400, Russell 2000, and Nasdaq all hit their lows for the years. Just as abruptly, they turned the next day and never looked back leaving investors wondering if the summer selloff was really over.
How We Got Here Early in the summer the U.S. had its own sovereign credit crisis to fathom. As the budgetless federal government bumped up against the national credit limit, Republicans refused play along without offsetting spending cuts. Until then, Congress routinely just raised the limit whenever it was needed, but this time was different. After three weeks (which seemed like three years)) of hard bargaining, an agreement was hammered out raising the credit limit and sticking a "Super Committee" with the responsibility of finding offsetting cuts by Thanksgiving. Both sides claimed victory, the national debt went up, and a true solution to the problem was put off yet again. It's non-solutions like these that kept investors on edge throughout the summer and into the fall. Every time the EU props up an insolvent nation, they merely delay the inevitable. No one is willing to buy Greek debt knowing it will be worthless whenever Germany and France finally pull the plug on the ongoing bail-outs. Greece will never be able to stand on its own under the remaining debt load, especially in light of the austerity programs forced upon it in exchange for the earlier handouts. The U.S. won't move forward, either, as long as politicians close their eyes to the source of the massive and rapidly growing deficit -- entitlement programs that simply cannot continue to be funded at today's growing levels. Investors realized this and naturally pulled out of the market last summer. Instead they were willing to huddle in the relative safety of low-yielding government securities. Even if it meant losing to inflation, it was better than suffering through the daily volatility of the equity market. While certainly a rational response to current conditions, this could also be the catalyst for the second leg of a double-dip recession.
Coming Attractions This rally, too, came to an abrupt end when Greek Prime Minister George Papandreou surprised the markets (and his own party) by announcing the EU's bail-out offer would be put to a national vote. Greek citizens, having already demonstrated their opposition to the EU's austerity measures, were highly unlikely to deliver a favorable vote. Markets around the world tumbled as forces both inside and outside Greece worked feverishly to reverse Mr. Papandreou's decision. Three days later the referendum was just a bad memory and stocks again reacted positively. It may not always be apparent, but European leaders realize Greece's only real alternative to the bail-out is a messy default which threatens to spread across the euro zone. One way or another, the bail-out will continue. But even if the euro zone's debt crisis can be contained, another headline-grabbing debacle is about to unfold back in the U.S. With October gone, Thanksgiving is now less than a month away. Usually that means the holidays aren't too far behind but this year it means the Super Committee is about to emerge with its recommendations. Already news leaks claim the Democrats and Republicans of the committee are still far apart on the thorny questions of tax and entitlement reform. Failure to agree launches a series of deep cuts to military and entitlement spending, something both sides would prefer to avoid. Like their European counterparts, U.S. politicians could stand a little backbone. Finger-pointing may make good headlines, but what's really needed is a major reconsideration of existing entitlement programs and tax policy. Hard decisions must be confronted and not everyone will get what they want -- in fact, they're more likely to be called upon to sacrifice a few tax dollars or even drop a few entitlement benefits. The over-promising and under-funding must end if the nation is to get its fiscal house in order. Even with the best efforts of the Super Committee, next year's upcoming elections make this highly unlikely. Few politicians are willing to run on a platform of austerity. That doesn't mean there won't be daily headlines to drive the market. Quite the contrary, just as battle lines were sharply drawn as the rhetoric heated last summer, this fall promises more of the same. Businesses are afraid to invest in the face of potentially higher taxes. It also doesn't help that politicians seeking the populist vote are making a living demonizing free enterprise and capitalism. Without investment, the nation's jobless level is and will remain over 9% for the near future. Consumer confidence while not plummeting, has consistently remained low. None of this will change until today's fiscal problems are truly addressed. Short-term tax-breaks and fixes won't work, we've already seen that. Only long-term changes will instill confidence in consumers, businesses, and investors. In the meantime, stocks will muddle along with the headlines. Bonds, whose yield began to drift up with the October equity rally, have probably moved into a new trading range of 2.0% - 2.5% on the 10-year Treasury. As they did all summer, they'll continue to move inversely with stocks as investors play the risk-on/risk-off game. Historically, market watchers tend to become more bullish as the year draws to a close, as they set their sights on the coming twelve months. However, just as the European credit crisis was able to overshadow generally positive third quarter earnings, all the debate surrounding the recommendations of the Super Committee is likely displace the Santa Claus Rally and the prospects for fourth quarter earnings. As long as the current fiscal problems go unaddressed, it will be difficult if not impossible to sustain a real bull market. When volatile headlines dominate the market, businesses', consumers', and investors' bottom lines suffer. Search this site! Just enter you key word or words:
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HERE'S A COMMON MISPERCEPTION that October is the worst month of the year for stocks. It's understandable given the crash of 1929, the sharp selloff in 1987, and 2008's credit crisis all occurred in the month of October. However, truth be told, most of the selling over the past century has actually occurred in September, October was merely the culmination -- and that's exactly what happened this year.
