We’ve already seen investors miss the greatest bull market of the past 70 yearsdue to panic selling from the 2008 bear market. Now, it looks like the same panicked selling caused investors to miss out on big gains once again.

Investors withdrew almost $18 billion from the market in October, marking the sixth straight month of withdrawals seemingly in response to the market dip we experienced from May through September. It was bad timing, as the S&P 500 Index returned almost 11 percent in October, more than the annualized return the market has provided over the long term.

Study after study shows that the returns investors earn are well below the return of the very funds in which they invest. Advisor, columnist and author Carl Richards coined the phrase the “behavioral gap” to label the difference between investor returns and investment returns.

The gap is created because investors persistently follow a pattern of buying high after a period of strong performance (as greed and envy take over) and selling low after a period of poor performance (as fear and panic take over). They sell when things go bad, when valuations are low and expected returns are high. Then they buy when the coast appears to be clear, when valuations are high and expected returns are low.

Surely investors can’t believe that buying when expected returns are low and selling when they’re high is a good strategy. Yet, they persistently repeat this behavior.

If you find yourself reacting to the noise of the markets, allowing your emotions to take over and following this cycle, it’s time to break the pattern of destructive behavior. Admitting you have a problem of addictive behavior is the first and necessary step on the road to recovery. However, it’s not a sufficient one.

The second step is to write and sign and investment policy statement, one that defines your goals and makes sure your asset allocation doesn’t cause you to take more risk than you have the ability, willingness or need to take. My book,The Only Guide You’ll Ever Need for the Right Financial Plan, provides you with the knowledge you need to build that plan.

The third step is actually the hardest, having the discipline to adhere to the plan. Helping investors do that is perhaps the most important role a financial advisor plays.

As advisors and students of financial history, we know that investors hate uncertainty. While most of us understand that only legends in their own mind have perfect clarity as to the future, when presented with conditions that create a heightened sense of uncertainty, even investors with well-designed plans react, letting their emotions and stomachs take over. And stomachs don’t make good decisions. Fear, and eventually panic, tends to set in.

Unfortunately, we can’t remove the uncertainty that may have your stomach rumbling. While it seems to be an all-too-human need to believe that there’s someone who can protect us from bear markets, the evidence from academic research demonstrates that no such person exists. All crystal balls are cloudy, including mine.

Instead, I’d like to provide some perspective on what has been happening and to prevent you from committing costly errors — failing to differentiate information from insights you can use to outperform the market and engaging in what I call “stage one-thinking.”

Information or Actual Insight

Let’s start with confusing information with insights that can be used to outperform the market. The wrong way to think about all the bad news is to believe that prices must go lower. The right way to think about all the bad news is to understand that prices are where they are because of the bad news. In other words, if the news was bad, but not quite so bad, prices would actually be higher. In addition, low current valuations mean that future expected (though not guaranteed) returns are high. So before you sell, you should ask yourself: “Does it make sense to buy when valuations are high because things look safe, and expected returns are low? And does it make sense to sell when things look dark and valuations are low and expected returns are high?” That doesn’t seem very rational. Yet, that’s exactly the behavior of most investors. Consider the following.

On March 9, 2009 the S&P 500 closed at 676. By the close of May 2, 2011, it had more than doubled to 1,361, and that doesn’t count the return from dividends. How were investors reacting during the greatest bull market since the 1930s? They were withdrawing hundreds of billions of dollars from equity mutual funds. That’s why it has been said that bear markets are the mechanism by which wealth is transferred from those without plans, or the discipline to stick to plans if they exist, to those with plans and the discipline to adhere to them. Those who stuck to their plans in 2008-2010, simply rebalancing, were able to buy at low prices, when expected returns were high, and then sell (at much higher prices) when markets had recovered, taking precious chips off the table. In addition, the gains for some were so great that they were able to lower their equity allocation and still be likely to achieve their life and financial goals.

As was noted earlier, we don’t have a clear crystal ball as to the outcome of this or any other crisis. It’s certainly possible that the uncertainty in Greece and other countries could drag on for months without a solution, in which case risk premiums would likely expand, creating the potential for a repeat of 2008 in terms of the depths of a bear market. It’s also possible that we could quickly get agreement on a broad solution, including recapitalizing the banks. That would restore confidence, risk premiums would likely contract sharply, and all the losses could be quickly erased. There’s simply no way to know what scenario will play out.

Stage One Thinking

I would now like you to consider the following situation: You have back pain. You visit two doctors. Each reviews the MRI. The first states that she’s seen many similar cases and that it’s hard to say exactly what is wrong, as it’s hard to predict what will work for any one person. She suggests you try Treatment A first, and then go on from there. The second doctor states that he knows exactly what is wrong and what to do. Which doctor do you choose? Almost always people will choose the latter. Yet, that might very well be the wrong choice. While we want certainty, it rarely exists. And it certainly doesn’t exist in the investment world where so much of returns are explained by unforecastable events such as Mideast revolutions, Japanese earthquakes and tsunamis and the attack on the World Trade Center buildings. Remember this example the next time someone tells you they know what is going to happen to the market. Also remember that the academic research on forecasting clearly demonstrates that as much as we would like to believe there are those who can predict the future, prognosticating is the occupation of charlatans.

I’d now like to turn back to the second of the two costly mistakes I mentioned at the beginning that far too many investors make — they limit their thinking to “stage one.” Let me explain. When there are crises, investors focus on the negative news and fail to consider the likelihood, if not certainty, that governments and central banks will act to try to resolve the crises and restore their economies to a healthy state. Those who engage in “stage two” thinking understand that crises lead to actions to counter the problem. (In fact, it often takes crises like our budget crisis to get governments to act.) Faced with crises, governments typically enact stimulative fiscal policies, and central banks implement stimulative monetary policies. Those policies often take time to produce results, but markets are forward looking. That means that well-designed policies will typically lead to the financial markets recovering well before the economies recover.

This is why the stock market is one of the government’s nine components of the index of leading economic indicators. The failure to think beyond stage one and look to stage two causes panicked selling and the resulting sell-low/buy-high outcomes most investors experience. And because it often takes a crisis to get the action, and the more severe the crisis the more likely you will get action and the stronger the measures are likely to be, the more likely it is that if investors limit themselves to stage one thinking, the more likely it is they will sell just before the markets begin to recover.

There’s one other critical point we need to cover regarding stage-one thinking. Those who decide to sell until the “green light” comes back on, indicating that it’s once again safe to invest in stocks, don’t understand that there’s never a green light when it comes to equity investing. It’s never safe to invest. There’s always a high degree of risk. For example, if you had sold in March of 2009, when would have it been safe to again invest in stocks?

• The unemployment rate continued to rise and stay at very high levels.
• We had a series of mid-East revolutions.
• North Korea launched an attack on South Korea.
• Our budget deficit problems have not been solved in any way.
• The U.S’s credit rating was downgraded.
• Oil soared from below 50 to well over 100.
• We had the PIGS crisis.
• We had a flash crash.
• Housing prices continued to fall.
• Hundreds of banks failed.
• Let’s not forget Meredith Whitney’s dire forecast for municipal bonds.

There never was a green light, which was why most investors missed the rally. And there never is a green light. So if you decide to sell, you must have a plan to get back in. But there’s really no effective way to design such a plan, because history is likely to repeat itself, and you’ll be trapped in a vicious circle of buying high and selling low.

There are very few investors who can avoid all risks and still achieve their life and financial goals. And the evidence against trying to time the market is that efforts are highly unlikely to prove successful. That means that the strategy most likely to allow you to achieve your goals is to abandon hope of trying to time the market, and instead focus on the things you can control:

• The amount of risk you take
• Diversifying the risks you take as much as possible
• Keeping costs low and tax efficiency high

In other words, while the advice to stay the course may not seem to be the most satisfying of answers, we believe the evidence demonstrates that it’s the right one. The last thing investors should do in response to a crisis, or any period of volatility and uncertainty is to let their stomachs take over.

Before closing I would like to discuss one other issue, diversification. Today, I hear many people saying the U.S. is the safest place to invest. That is probably a result of the S&P 500 Index outperforming the MSCI EAFE and MSCI Emerging Markets Indexes. However, the proper perspective is that this crisis demonstrates that international diversification is important. All one has to do is to think about the issue from the perspective of a European. If one of them had chosen to limit investments to the countries of the European Monetary Union, they would certainly be regretting it today.

In conclusion, the key to successful investing is to understand what Napoleon knew — most battles are won in the preparatory stage. For investors that means having a plan that incorporates the certainty that they’ll have to face many crises over their investment careers. Therefore, it’s critical to not take more risk than you have the ability, willingness or need to take. A Monte Carlo simulation can help you determine the right asset allocation for you. If your stomach is roiling now, check to see if you are able to lower your equity allocation and still be able to achieve your goals. And if you find that is not the case, then you should at least consider lowering your goals, spending less now (saving more so don’t have to take as much risk), or planning on working longer.

Before closing, I offer these words of wisdom. It’s critical to remember that once something bad has happened, and we know the outcome, it’s too late to act because markets have already done so. You have already taken the risks and incurred the loss. Any reaction at this point is likely to be an overreaction, caused by panicked selling.

And finally, I would like to note what I consider to be an amusing irony. While most investors revere Warren Buffett, they ignore virtually all of his advice, including his advice to ignore all market forecasts and his advice to not try and time the market, but if you do you should buy when others are panicking and sell when others are getting greedy.

Charles Schwab
By Liz Ann Sonders & Michelle Gibley
September 12, 2011

The inevitability of the eurozone crisis was foreshadowed by the late, great economist Milton Friedman. At the time of the euro’s debut in early 1999, Friedman expressed concern that it would not survive the first major European economic recession or crisis. Prescient thinking. 

Euro 101 
The primary motivation for the creation of the euro was less economic than political. The goal was an integrated Europe that could more effectively compete with (and/or rival) the United States. The hope was that a single currency would also force economic restructuring in the more-wayward peripheral countries, requiring them to abide by the Maastricht Treaty rules that govern member countries’ budget policies. 

Things didn’t work out as planned. Blatant disregard for budget policies among the “PIIGS” nations (Portugal, Ireland, Italy, Greece and Spain) brought on wage and price inflation greatly exceeding the eurozone average. In addition to the resultant diminished competitiveness of these peripheral members was the effect of burgeoning budget deficits as a percentage of their gross domestic products (GDP). 

Fast-forward to today, and there’s legitimate risk that these countries don’t have the wherewithal to honor their debt obligations. The major problem is that European leaders don’t appear (at least publicly) to understand either the gravity of the crisis or the impact that confidence has on the financial system. The very recent decision by Germany to begin contingency planning and shore up its banking system suggests perhaps they are just getting to this point of awareness. 

Not contained to Europe … 
The pressures emanating from the overhang of government debt in the eurozone continue to negatively impact trading in Europe, but why have US stocks also been taking their cues from the eurozone? Why does Greece matter so much? 

Because the crisis is about more than just Greece. The problems in the eurozone are more about the health of the banking system in Europe, the long-term viability of the euro, Europe’s contribution to global growth and the indirect impact on the US dollar.
 
… but Greece is unique in severity 
Greece’s deficit and debt levels (15% and 140% of GDP, respectively), lack of economic growth and commitment to austerity put it in a class of its own, and Greece is the most likely member to default on its debt. Greece’s quarterly review for funding conducted by the troika of the International Monetary Fund, European Commission and the European Central Bank (ECB) broke down in early September. The breakdown was due to lack of progress on achieving fiscal targets, implementing structural reforms, selling off public assets (privatization) and a public debt-swap plan rumored to be short of the 90% participation goal. 

In an illustration of Greece’s struggle, the ability for Greece to generate the revenues targeted under the bailout is severely hampered: the economy contracted 7.3% in the second quarter and Greek officials have confirmed that they have cash for only a few more weeks. If this sounds familiar, it is: Greece was in the same position in mid-July of this year when cash was running low because the deficit was higher than expected. 

This was partly due to lack of progress on austerity and reforms, leading to the second Greek bailout to cover higher-than-expected cash needs. Since then, yields on Greek two-year debt have skyrocketed relative to the other peripheral nations.

Greek Two-Year Bond Yields Go Parabolic 

Source: FactSet, as of September 9, 2011.

So is forcing more austerity on a country already suffering from a lack of economic growth the solution, or will this just exacerbate the problem? It’s clear to most observers that this is an unsustainable situation, with a restructuring of debt obligations ultimately needed. 

Contagion from Greece is infecting the European banking system 
Policymakers have been hoping to postpone a Greek debt restructuring until growth recovers, reforms have been put in place and banks have had a chance to better capitalize to cover potential losses. However, the lack of agreement and ability to act in a coordinated way by eurozone policymakers has allowed a crisis of confidence to develop, resulting in contagion to other countries and a banking-system infection. As a result, banks are less willing to lend to each other, as highlighted in the chart below by the widening in the three-month Euribor/EONIA spread, indicating a growing credit crunch.

European Bank Stress Up, But Below 2008

Source: FactSet, as of September 9, 2011. Europe Bank Stress=three-month EURIBOR (Euro Interbank Offered Rate) minus three-month EONIA (Euro Overnight Index Average) swap rate.

There’s a question of which came first, the chicken or the egg here, but the interaction between banks and governments appears to be reinforcing this negative feedback loop. Reasons include:

• Banks have large holdings of sovereign debt which they may need to write down.
• Governments tend to be the backstop for banks.
• Yields on government debt are often the basis for loan rates.
• Banks themselves can have funding issues if they’re using government debt as collateral for loans.

As a result, we believe European banks need more capital. Reasons include: 

• Eurozone banks have low levels of capital. European banks remain highly leveraged, not having recapitalized or deleveraged to the same degree as those in the United States. According to Michael Cembalest, head of JP Morgan’s private bank, European banking-sector liabilities are three-to-four times the size of European GDP, versus the one-to-one ratio in the United States.
• It’s likely that sovereign debt (Greek in particular) will have to be written down further at many banks. While the proposed second bailout for Greece forced a 21% write-down of some Greek debt, markets are pricing in more than a 50% discount, in line with the haircut many believe is sustainable for Greece to support.
• There’s a need to bolster confidence that banks can absorb losses. Banks’ overreliance on short-term funding has exacerbated uncertainty and volatility, and investors need comfort before providing capital.
• Banks must have the strength to lend—the lifeblood of economic growth.

Why not let Greece default and stop the contagion? 
Some believe that separating Greece’s solvency issues from liquidity issues elsewhere by drawing a line in the sand and recognizing that Greece needs restructuring may ultimately be a positive action. While this could be destabilizing in the near term, it’s possible that by sizing asset values and removing uncertainty, markets could form a base from which to build. 

The problem for markets is that we just don’t know the broader implications of a Greek default on European banks or contagion to the other PIIGS. Banks across the eurozone own Greek debt, and Greece is only one of the three countries currently under bailout (Portugal and Ireland being the others), while the debt of the other two PIIGS (Spain and Italy) is currently being propped up by ECB purchases. An immediate default without a longer-term plan to “ringfence” banks and other sovereigns (like Italy) would be quite risky. 

The question is whether the value of the debt of these other countries will also be marked down and whether Portugal and Ireland will decide to either default or ask for new conditions. Lastly, the lack of transparency in the credit default swaps (CDS) market means we don’t know where all the liabilities exist. 

Ultimately, it’s unknown how much additional capital eurozone banks would require if contagion spreads, but it’s believed that even including CDS exposures, US banks would feel little impact. The chart below shows the direct exposure of US banks to PIIGS’ sovereign debt, relative to the European banks.

US Exposure to PIIGS Limited

Source: BCA Research and Ned Davis Research (NDR), Inc. (Further distribution prohibited without prior permission. Copyright 2011 (c) Ned Davis Research, Inc. All rights reserved.). Debt as of December 31, 2010, and includes public and private. GDP as of June 30, 2011, and expressed in nominal terms.

US banks’ capital ratios are about double those of the average European bank. In addition, many banks claim that their “net” (including CDS) exposure is limited. But as we learned through the Lehman Brothers debacle in 2008, if you have “insurance” via CDS, but the party on the other side (AIG at the time of the Lehman failure) can’t pay the claim, a can of worms is opened. (You can see a chart of Greece’s CDS further below.) 

Meanwhile, the ECB’s ability to purchase debt, which has helped ease pressure in Spain and Italy, is limited by its need to sterilize (offset) injections of money into the financial system with withdrawals of liquidity elsewhere. Discouragingly, even the ability of the ECB to stabilize the situation has been hampered. 

Greek default may force decision between euro breakup or fiscal union 
A potentially bigger-picture implication of a Greek default is whether it would come in conjunction with a decision to leave the euro, either voluntarily or involuntary. In the near term, Greece leaving the euro and returning to the drachma could result in debt defaults for businesses and households, require banking system recapitalization and disrupt international trade. There would need to be strong coordinated action in the eurozone to stabilize the situation and keep things orderly—something that’s been lacking thus far in the crisis. This may ultimately require coordinated global central-bank intervention. 

Any country opting (or forced) to leave the euro would find the process a lengthy one. An exiting country would have to negotiate with the entire European Union (EU), not just the eurozone authorities. All treaties and legislation governing the euro are EU treaties. In fact, several of the 27 countries encompassing the EU require referenda to be held on changes to treaties. 

On the other side, a full eurozone fiscal union may be desired but politicians must convince their citizens of the advantages. Additionally, many new laws and treaties would be required—which would not be an easy or quick process. To date, more-austere nations have been unwilling to consider measures toward fiscal union (such as issuing common eurobond debt) until bailout nations make more progress on austerity and reform. 

One outcome of the German court decision this week (that ruled the European Financial Stability Facility constitutional) is that it rules out open-ended, longer-term fiscal responsibility for other nations, thwarting the possibility of eurobonds. The flaw exposed during this crisis is that a currency and monetary union without fiscal union may not be sustainable. 

Greek CDS surge 
The choice will be between kicking the can down the road again or removing the band-aids and taking the short-term pain. Over the weekend, Greek officials indicated further measures to close the deficit gap for this year and renewed their commitment to meeting obligations rather than default. Additionally, despite continued resistance to assist in bailouts and strong language that austerity and reforms agreed to must be adhered to, the German finance minster has rejected speculation of a Greek default. Markets remain unconvinced, as the CDS market is indicating a 92% probability of a Greek default.

Greek CDS Go Parabolic 

Source: Bloomberg and FactSet, as of September 9, 2011.

It’s also important to note that both Italy and France five-year CDS have increased sharply, indicating that contagion has begun. We don’t know when a Greek default will happen, and it is possible the can will be kicked down the road again before a restructuring ultimately occurs. Additionally, while the current negative sentiment may end up presenting the possibility of a short-term bounce for stocks, we await better visibility on a resolution to the eurozone crisis before changing our cautious outlook on the eurozone. 

2008 redux? 
Whether we’re heading on a path to repeating the 2008 crisis is a question we often receive. There are many indications that the global banking system is in far better shape today than it was back then and that the crisis is likely to be relatively contained to the eurozone. But we don’t take pictures like the one below lightly either.

Foreign Banks Shovel Money to Fed

Source: FactSet and Federal Reserve Bank of St. Louis, as of September 9, 2011.

Foreign official and international accounts have deposited nearly $103 billion at the US Federal Reserve, up from less than $58 billion at the beginning of 2011 and well above the prior crisis high of less than $89 billion in January 2009. This indicates a loss of trust in the European banking system. 

Lars Tranberg from Danske Bank said European banks have been reduced to borrowing dollar funds for “a week at a time,” as opposed to the typical six-to-12 months. “This closely resembles what happened in late 2008, though the difference this time is that the major central banks have dollar swap lines in place. If the dollar funding market completely freezes up, the ECB can act as a backstop.”

Growth under attack in the eurozone, pressuring the global economy 
The eurozone is an important part of the global economy, as it accounts for nearly 20% of global GDP. While the eurozone has not recently been a big driver of growth, a breakdown in economic growth or the banking system would be felt globally. With growth already slowing globally, a recession in Europe would hurt. While we think a recession in several European countries is very likely, we believe a broader global recession akin to that experienced in 2008 can be avoided. 

As a result of falling confidence in the longer-term viability of the euro and the potential that the ECB may need to pursue its version of quantitative easing by making unsterilized purchases of either sovereign or bank debt, the value of the euro has fallen. There’s also pressure (rightly so) on the ECB to lower short-term interest rates. 

This has resulted in a corresponding increase in the US dollar, as you can see in the chart below. History is mixed as to whether a stronger dollar (which we expect) would necessarily be negative for the stock market. Recently, the two have moved inversely, but over long-term history, a stronger dollar has more often been met with a stronger stock market. Regardless, a stronger dollar would mean weaker profits for multi-national companies, but less inflation. 

US Dollar Breaks Out on Upside

Source: FactSet, as of September 9, 2011.

What’s next? 
The situation in the eurozone remains fluid, with key events still ahead, including final approval of the new Italian austerity package, French banks bracing for a potential downgrade by Moody’s and the European Commission pushing for a global agreement on a potential financial transaction tax later this month. 

Importantly, the second Greek bailout and expanded European Financial Stability Facility has yet to be ratified by the parliaments of all 17 nations that comprise the euro, which is expected to occur in September and October. Additionally, Finland’s demand for a collateral guarantee in exchange for its bailout contribution is expected to be resolved in mid-September. 

What’s an investor to do? 
This all begs the question about how an investor should be thinking about portfolio positioning. From a stock perspective, we continue to think that the US market will remain a decent relative performer (though not necessarily a decent absolute performer). In fact, on a year-to-date basis, the US stock market is ranked seventh among the 33 largest stock markets globally. And we know readers will be shocked, just shocked, that Greece’s stock-market performance is dead last.

While we’ve been negative on Europe, we don’t believe in completely avoiding the continent, but instead supplementing diversified European exposure with an allocation to Switzerland’s defensive market. Elsewhere, we’re favorably disposed to Japan, where we believe there’s an improving environment in which companies can operate more competitively globally. In combination with low expectations and declines in valuations, it could bring about the long-awaited revival of Japanese stocks. 

Lastly, we believe the global economic slowdown and strength in the dollar may provide emerging markets with inflation relief. That would enable a pause in monetary tightening to the potential benefit of stock-market performance, once the uncertainty and high correlations (degree to which asset classes move in tandem) eases.

Important Disclosures

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

  (c) Charles Schwab

http://www.schwab.com/

Fundamentally, however, the downgrade doesn’t mean anything but a shameful PR black-eye for America.  The market had priced the news in, to a large degree, but Monday’s open will adjust it down further.  What this political theatre of the last 45 days has done, however, is taken a relatively healthy economy and scared it and its participants out of their minds – and not unjustifiably.  That fear and lack of confidence has trickled into the recent economic indicators, and this downgrade news won’t help.  One good piece of news from this mess?  The price of oil has fallen to $84 per barrel this weekend, making the pump a little less painful (it was at $115 just three months ago).

Without the downgrade news, I was anticipating a sharp move higher for stocks early this week.  Three indicators that only come around at rare inflection points are screaming “buy”.  These indicators have literally been correct 100% of the time.  Each signaled the end of corrections or bear markets in 1987, 1990, 2003, and 2009.  The other was last Friday.

The urge is strong to say “it’s different this time”.  But stocks never drop 12% in ten days for no reason, it’s always a crisis or shock that does the damage.  This mess is a serious shock, but simply another negative driver nonetheless, just like all the others in history.  My sense is that based on the global economic condition, we could be looking at putting some of our substantial cash reserves to work soon, once the dust settles.

An interesting piece of data from Bespoke Investment Group points out just how rare this August has been thus far, and what that could mean for the rest of the year:  The 7.19% decline the S&P 500 has seen over the first five trading days of August is the worst start to the month in the S&P 500′s history going back to 1928.  The next worst start to August came in 1990 when the S&P declined 5.99% over the first five trading days.  For what it’s worth, the index continued to decline for the remainder of August in 1990 by 3.66%.  It then rallied slightly from September through the end of the year.

There have been three other starts to August where the S&P declined more than 3% (1982, 2002, 2004), and in each of these instances, the index gained significantly for the remainder of August.  In 1982, the S&P then went on to gain 35.61% for the remainder of the year, and in 2004, the index gained 13.91% over the rest of the year.  In 2002, the index was essentially flat for the remainder of the year after dropping 3.82% in the first five days of August.

 ”Buy and pray” won’t work anymore than jumping in and out of the market on gut or fear.  Staying diversified, unemotional, and rebalancing when opportunities arise will work in this environment, as it did in 1987, 1990, 2003, and 2009.  As will keeping your portfolio in line with the long-term goals we set in place at the outset.  I will be in touch this week with further updates.

Regards,

Brett

The debt ceiling negotiations have taken center stage and it seems they’re all anyone cares about at the moment. Bank Credit Analyst (BCA) wrote in a recent report, “…it seems that short-term, vicious circles of debt crisis, policy paralysis and a sickening banking system are intertwining with the bleak, secular trend of debt, deficit and growth stagnation, to create a weird miasma of both complacency and despair.”

Interestingly, BCA was writing about the eurozone debt crisis (which has now troublingly spread to Italy), but it also characterizes our own problems here in the United States. Two major ratings agencies, Moody’s and Standard & Poor’s, are certainly weighing in with their consternation by threatening to lower the US Treasury’s AAA rating.

Having gotten the subprime crisis so very wrong, the agencies have stepped up to try and redeem themselves by getting ahead of the curve on US and other sovereign debt ratings via downgrade threats. S&P went as far as specifying that it’s looking for a very large deal of around $4 trillion over 10 years to accompany the raising of the ceiling.

Market reactions?
Today, I want to lay out in a little more detail possible market reactions as we head toward the deadline of August 2 (which in reality is July 22, since time is needed to pen a bill’s language).

Assuming the United States did indeed default on its debt (which we believe is still extremely unlikely), most investors and certainly the media believe it would be calamitous for both the stock and bond markets. A worst-case scenario would have Treasury yields rising significantly, bringing other yields up alongside, representing a material tightening of financial conditions in less-than-perfect economic times. The dollar would likely drop, as would stocks—perhaps meaningfully so.

I don’t disagree with that pessimistic assessment, but I still wouldn’t attempt to handicap or forecast moves by any asset class. There’s a more-benign, albeit non-consensus view that markets may not move as dramatically as many are assuming. In fact, it’s supported by the so-far benign moves by both stocks and Treasury bonds as we’ve approached the deadline.

Demand for Treasury securities has remained strong throughout the debt-ceiling debate and stocks have been volatile, but not starkly weak. This suggests investors don’t believe there will be a default and/or that Treasury prices are reflecting the global soft patch.

A default (particularly if it was short-lived) could cause the stock market to fall to the lower end of the trading range it’s been in for more than a year, but may also provide some support for stocks if it triggers more meaningful negotiations and ultimately a bigger deal on debt/deficit reduction. Bonds might also rally under a more-benign scenario due to the reduction in government spending, suggesting a lessened need for Treasury financing going forward. A smaller supply of Treasury notes and bonds via issuance could lead to higher prices. This is not my base case, but I think it’s always important to review every possible reaction by markets.

History as a guide?
We don’t really have much history to go on to gauge market reaction except for other countries that have lost AAA ratings. S&P downgraded several European countries (Belgium, Ireland, Italy, Portugal and Spain) from AAA in May 1998—a week later, 10-year bond yields for those countries were only slightly higher; a month later they were actually slightly lower; and a year later they were nearly 1% lower.

Japan lost its AAA rating in February 2001. A week later its 10-year bond yield was flat; more than 0.3% lower a month later and only slightly higher after a year. As noted by ISI, both the European and Japanese experiences suggest that other factors, such as the market’s own opinion of a country’s creditworthiness and broad macro and policy trends, may be more important than official credit ratings in determining a country’s borrowing costs.

We can look at past government shutdowns as a pseudo-proxy for what we might expect. The most recent US government shutdown was from December 13, 1995 to January 6, 1996. The Dow Jones Industrial Average actually rose about 2% during that period.

What to do?
We’ve heard a lot of questions about what investors should do in their portfolios to account for the risk of a default. We continue to preach the benefits of diversification among and within asset classes, both domestic and international.

There are indications that many investors have moved money into other currencies and gold, and are buying insurance against the possibility of a US default. Supporting those moves: the dollar has taken a fresh turn down, sharply relative to the Japanese yen; gold has hit record highs over the past two weeks; and the price of US Treasury credit-default swaps have risen by about 20% since early April.

Why not just recommend investors flee to cash? Even if you did put all your money under your mattress (if only figuratively), you’d have problems if inflation accelerated, not to mention the opportunity cost in the event of a substantial relief rally in stocks and/or bonds.

Any progress over the weekend?
There doesn’t appear to have been much forward movement over the weekend. This week Republicans will hold a House vote on a balanced-budget amendment that limits government spending and makes it difficult to increase taxes. Although success in the House is expected, passage in the Senate is unlikely.

As noted by ISI, unless a deal is reached between President Barack Obama and House Speaker John Boehner (R –Ohio), the Senate seems poised to vote on some version of the proposal from Sen. Mitch McConnell (R –Kentucky), which would raise the debt ceiling and cut $1.5 to $1.8 trillion in spending. It would create the possibility of another major round of deficit reduction for later this year or early next year. But the McConnell approach has not been well received by either political party in the House, so passage is far from certain.

In the meantime, a lot has happened over the past couple of weeks. The Federal Reserve’s second round of quantitative easing (QE2) came to an end and a rash of economic reports have been released, including the second consecutive weak jobs report.

Unemployment claims are just coming down from a troubling spike, but are not yet back into the sub-400,000 comfort zone. The Empire Index for July was weaker than expected and the University of Michigan consumer sentiment report was a real dud, although I think the debt ceiling debate was a major contributor to that weakness versus elevated concerns about the health of the economy. Home prices may be stabilizing, with the Case-Shiller index down only 0.1% in April.

As hard as it can be in a volatile period, I remain optimistic that we’ll see a deal struck before August 2 and that the second half of the year will see a pick-up in growth. I’m often asked about “favorite” indicators and I want to highlight one below. Thanks to the Fed keeping short rates on the floor and longer-term yields remaining near 3%, the spread between the 10-year Treasury yield and the fed funds rate is near an all-time high. For those fretting a double-dip recession, note in the chart below that spreads this steep in the past have occurred well before recessions have begun.

Yield Curve Says Recession is Far Off

Source: FactSet, Federal Reserve, ISI Group, Ned Davis Research, Inc., as of July 15, 2011. (Further distribution prohibited without prior permission. Copyright 2011 Ned Davis Research, Inc. All rights reserved.) Dotted line represents most recent peak.

On top of that, the global central bank tightening phase may be over as China’s Premier Wen Jiabao has publicly said China’s inflation problems are waning. And even though the European Central Bank’s latest tightening was roundly criticized for its improper timing, the futures market is showing the next move by the ECB to be a rate cut.

Fed and QE3
Another reason for hope can be seen when looking at the lending environment, particularly post-QE2. Although Fed Chair Ben Bernanke troubled markets on Wednesday and Thursday last week when it was perceived he was hinting at QE3 during testimony before Congress on Wednesday before seeming to back-track the following day.

Bernanke is keen to avoid two major mistakes made by the United States and Japan in the past. In 1937, the Fed halted a recovery by tightening policy too soon. In the 1990s, Japan failed to convince markets that they could fight systemic deflation.

Regardless of the market misreads of Bernanke’s position, we believe his view is simply that all options remain on the table—that QE3 would only be announced if both of the Fed’s mandates, stable prices and maximum employment, are breached. In other words, the Fed would need to see a significant deflation risk emerge anew and significant further deterioration in employment.

After all, the United States is no longer facing a liquidity crisis, as it was back in 2008 and 2009. As you can see below, borrowing has picked up (albeit from a very depressed level).

Lending Picking Up

Source: FactSet, Ned Davis Research, Inc., as of July 8, 2011. (Further distribution prohibited without prior permission. Copyright 2011 Ned Davis Research, Inc. All rights reserved.) Data prior to March 31, 2010, adjusted by Ned Davis Research, Inc. to reflect FAS166 and FAS167 changes.

Earnings looking good
Finally, another reason for hope beyond the debt-ceiling debate comes courtesy of corporate earnings. We’re still early in the reporting season for second-quarter earnings, but so far about 75% of companies have beaten expectations, which is historically high. Beats have been across a broad range of industries and sectors and earnings are on track to surpass their 2007 peak.

In sum, however, the debt ceiling is still a big cloud overhead. It has likely driven confidence way down, but other downside risks remain. Washington must act soon to restore confidence by getting a deal done.

As you might expect, I’ve received lots of calls and e-mails asking what to do about the impending crisis surrounding the debt ceiling. So I thought I’d share my thoughts.

As I noted in my post on the Greek crisis, the first and most important point is that if you have a well-developed investment plan, it will have anticipated crises (which by definition aren’t predictable or we would avoid them) and incorporated the virtual certainty that they’ll occur.

In other words, we live in a world of uncertainty. As Napoleon Bonaparte stated, “Most battles are won or lost [in the preparation stage] long before the first shot is fired.” That means we shouldn’t take more risk than we have the ability, willingness or need to take. Having a plan that anticipates severe bear markets gives you the greatest chance of staying disciplined and avoiding panic selling. Without a plan, you’re much more likely to allow your stomach to make investment decisions, and stomachs don’t make for good advisors.

Returning to the debt limit problem, it certainly is true that this crisis creates the potential for another financial “meltdown,” especially when we consider that there’s a similar crisis on the other side of the Atlantic — a crisis in Greece that has the potential to rapidly spread to Ireland, Portugal, Spain and even Italy. These crises taken together — or even separately — contain the seeds for another “seizing up” of capital markets as occurred when Lehman failed.

Though my crystal ball is always cloudy, if that were to occur, it’s seems likely the valuations of all risky assets (stocks and bonds) would fall rapidly, and the more risky and less liquid the asset, the faster and steeper the fall. And since this time the crisis would encompass what U.S. investors consider the riskless asset (Treasury debt), it’s hard to even imagine what could happen. And investors hate uncertainty.

The risks are clearly great if we don’t get an agreement. The problem is that we don’t know what will happen. The crisis could be resolved, or we could see a default. We could also see defaults in Greece and other defaults might follow (or at least markets would likely worry about that happening), and we might also see the end of the Euro, and who knows what else.

I think it’s interesting to note that the stock market has risen in the past month despite these problems. On June 15, the S&P 500 Index closed at 1,265, despite:

• The failure to resolve the US debt ceiling problem
• No resolution on the Greek crisis
• Weakening economic data
• Rising unemployment
• The end of QE2 (which some gurus were predicting would lead to major problems for the bond and stock market alike)

On July 14, the S&P 500 closed at 1,308, up more than 3 percent (note:  as of July 19, the S&P 500 stands at 1,329).  And despite Moody’s warning of a downgrade of Treasury debt, the 10-year Treasury rate was unchanged at 2.98 percent. I seriously doubt anyone would have predicted that outcome. Certainly bond guru Bill Gross didn’t forecast this. He sold Treasuries back in March, and did so with a lot of fanfare. Yet just recently he started buying back Treasuries, at much higher prices.

So that brings us to what should YOU do about the situation. I can tell you what we are doing as advisors. We aren’t making any adjustments to client portfolios in response to the debt ceiling debate. The market is well aware of the fact that the debt ceiling discussions are ongoing and U.S. Treasury rates are still very low, indicating the market believes the debt ceiling will be increased and that financial market disruptions are unlikely. We believe that efforts to try to move in or out of the stock or bond markets in anticipation of what will happen aren’t productive.

Even if the worst case scenario materialized and the U.S. debt ceiling isn’t raised, it’s seems likely that it would be raised quickly if there were any subsequent disruptions in the financial markets. Also keep in mind that this is a political technicality more than anything and not an issue with the capacity of the U.S. government to pay its debts.

If you won’t follow our advice, just ask yourself what Warren Buffett is doing these days. Is he selling?

With that said, we have minimized exposure to European banks and governments. We moved money out of money market funds that had significant exposures to these credits and into what we believe are safer assets. That is a move you should consider, as it’s a classic example of Pascal’s Wager (the consequences of being wrong are really bad compared to the benefits if you’re right and no losses occur).

The bottom line is this: If your stomach is growling and you’re losing sleep worrying about the outcome, you likely either don’t have a well-developed plan or you were overconfident about your ability to deal with bad economic times. If the former is the case, then you should immediately develop a plan. If it’s the latter, you should probably rewrite your plan and permanently lower you equity allocation, because this likely won’t be the last crisis you’ll have to deal with.

Photo courtesy of Public Notice Media on Flickr.

Debt concerns have combined with soft economic data to weigh on markets and we’ve seen a bit of return to the “risk on, risk off” trade that dominated 2010. We believe this is a relative temporary phenomenon that should start to reverse toward the end of summer, but there are growing risks. Tenuous confidence among businesses and investors could again be shaken depending on how the debt crises are dealt with or if the economic soft patch lasts longer than we currently believe.

Small business confidence is tenuous

Source: FactSet, Natl. Federation of Independent Business. As of June 27, 2011.

For now, we continue to have a relatively optimistic view of the latter half of 2011, with stocks setting up for a potential rally. Corporate balance sheets remain flush with cash and earnings continue to hold up remarkably well, although we’ll get another update on that during the upcoming second quarter earnings season. Additionally, much of the bad news seems to be “known” and may already be reflected in stock prices, setting up the possibility for upside surprises as some of the temporary burdens begin to ease. Finally, investor optimism has taken a blow from the recent action, which is typically a contrary indicator—a potential good sign for the market in the coming months.

Debt decisions key
The focus has been largely on the European debt crisis, which is detailed below, but the US debt situation continues to add to uncertainty. We certainly don’t believe that there is any real risk of default by the United States due to not raising the debt ceiling, a view confirmed by the continued extremely low yields of Treasury securities; but we are concerned about the deal that may be made in Washington. It appears highly likely that the agreement will involve at least an agreement to cut spending by approximately the amount of the boost to the debt ceiling—likely somewhere around $2 trillion. Spending needs to be cut, but details are important including the timing of the cuts and whether there’s a bias toward budget gimmickry. If too much cutting is pushed out into future years, any short-term benefits to the recovery would be offset by longer-term continued uncertainty.

However, that risk can be softened by the US economy growing at a more rapid rate, much as we saw during the early 1980′s recovery. Government policies that add uncertainty into the market and stymie risk-taking and innovation only make the future bill more difficult to pay. At Schwab, we have long been advocates of free markets and capitalism as the solution to many of the perceived problems in the world. Increased regulation and government interference has already started to weigh on business and we believe is a large contributor to the reluctance of companies to put their massive cash balances to work. Uncertainty and concern over the health care bill and resultant costs, regulation on interchange fees in the financial sector, environmental decrees that raise the cost of doing business, and an uncertain tax policy as we continue to deal with our debt all contribute to business uncertainty. A more globally competitive tax policy, a rollback of some of the more egregious regulations instituted recently, more certainty with regard to the health care law and the new financial derivative regulations, and cuts to spending on entitlement programs would help. It’s important to convince businesses and ratings agencies that our country is on the right track in order to accelerate economic growth over the next several years and bring down the unemployment rate; while repairing housing, and increasing growth and tax receipts. This would result in a more tenable debt situation at both the Federal and state levels.

Soft data continues- transitory?
Uncertainty over the US government’s actions in advance of the August 2 debt ceiling expiration, combined with soft economic data contributed to the recent market correction. Regional manufacturing surveys have dipped into negative territory, jobless claims remain stubbornly above the key 400,000 level, and housing continues to scrape along the bottom. However, all has not been negative as the Index of Leading Economic Indicators rebounded strongly, gaining 0.8%, inflation remains relatively low, and the yield curve remains historically steep, which has typically been a good indicator of future economic growth.

We continue to believe much of the weakness can be explained by temporary factors, including the disaster in Japan, severe winter and early spring weather, and a spike in oil prices that has since reversed. It is the waning of these pressures that we believe will usher in a better second half of the year.

The Federal Reserve apparently agrees with this assessment as during their most recent meeting they came to the same conclusion and held steady on their policy. QE2 has now ended without much fanfare as Treasury yields remain historically low despite the lack of Fed support going forward. The asset purchases have not stopped, however, as the Fed will continue to reinvest money received from securities maturing in order to maintain the size of its balance sheet. Stopping this process would be a likely first step in the long road to a more normal policy. The Fed gave no indication of a fresh round of asset purchases, despite downgrading its economic assessment slightly, and signaled that the bar for such a move remains quite high.

We continue to believe the Fed should be considering moving toward more normal monetary policy. While the aforementioned factors are keeping money on the sidelines, the near-free ride banks are getting gives them little incentive to move out the risk spectrum on their loan portfolios. With the ability to borrow from the Fed at near-0%, and invest the proceeds in Treasuries, they earn a risk free 2.5-3.5%; and as seen below, that has enticed many banks to do just that.

Banks are holding Treasuries instead of making loans

Source: FactSet, Federal Reserve. As of June 27, 2011.

A rise in rates may provide the incentive needed to get money flowing through the economy, while also potentially strengthening the dollar, which could further pressure commodity prices down, helping US consumers while also attracting more foreign capital.

Greece: what still needs to happen
While near-term moves to avert a default in Greece have whipsawed global markets, we believe a default is not likely in the cards at this time. Meanwhile, exposure in the United States to a default of any one peripheral country is not definitively quantifiable but is likely small, reaffirmed by Fed Chair Bernanke in his press conference following the June Fed meeting.

The near-term liquidity strain, with Greece needing cash immediately to keep its government working and make interest and principal payments on its debt, was likely solved when Parliament passed the austerity package demanded by the ECB and IMF. However, longer term, there is a need for Greece to address its two main problems: too much debt (insolvency) and an inability to grow.

The current Greek “bailout” program is too reliant on austerity, which alone cannot work. As austerity increases in each successive change to bailout terms and funding, the recession deepens. The result can be a never-ending spiral of cutting spending and raising taxes because the pie never grows enough to support current spending policies, increasing the likelihood of default.

Even if Greece meets its austerity goals, grows inline with what are likely optimistic growth forecasts and privatizes government-owned companies and sells assets, debt as a percentage of GDP is forecasted to rise to 160%. This is unsustainable because the interest burden continues to rise and eats up an increasingly larger portion of the budget. This is no bailout. As such, Greece needs to restructure its debt, allowing it to wipe the slate clean and provide a strengthened position from which to grow.

Additionally, Greece needs to increase tax receipts by addressing growth and tax collection. Greece needs additional labor reforms to allow companies to more easily fire employees and adjust when times are tough. This would allow companies to be more efficient and productive, increasing profitability, and attract new businesses that are now starting in more business friendly eurozone countries. Greece’s economy remains largely in state-run hands; typically less efficient and less productive than privately operated companies. Additionally, measures should be put in to foster new industries.

Lastly, Greece needs to clamp down on tax evasion, improve tax collection and strengthen consequences for evasion, while simultaneously restructuring its tax code to make it simpler and more business friendly. It is estimated that somewhere between 30 – 40% of the activity in the Greek economy that might be subject to income taxes goes unrecorded. However, changes to address growth and tax collection will be slow, if they ever occur, and will take a long time before aiding Greece’s fiscal recovery.

Greece may need to exit the euro eventually, as it would allow the country to reduce the value of its currency, or devalue, in order to gain competitiveness through lower export prices, thus aiding economic growth. However, this is unlikely in the near-term and policymakers would need a policy to allow for exit. Additionally, closer European fiscal union could help keep deficits in line, but is unlikely due to political and cultural differences. Due to a true lack of union and disparate economies, the crisis has demonstrated politicians’ reluctance to achieve consensus, and a country leaving the euro is a possibility over the next five years.

While European stocks could rally after near-term Greek liquidity issues are addressed, we favor other regions longer-term, as we expect continued periodic scares about solvency in peripheral countries, which could create ongoing volatility and a cap on rallies.

Will synchronized slowdown result in synchronized upturn?
It is easy to find reasons to be negative when growth is slowing, but the economic slowdown and government debt risks are well-known at this point.

Meanwhile, some of the pressures on global growth are starting to ease. While there are near-term risks to Japanese earnings estimates and reliability of power supply, Japanese industrial production is bouncing back sharply. Reduced inventories in the supply chain for technology and automotive companies as a result of Japan disruptions are likely to be replenished over the summer, contributing to economic growth. Additionally, there have been some announcements from Japanese companies to undertake actions to increase their competitiveness and profitability, an optimistic development. Japanese stocks may have more upside than downside from here.

Japan production returning

Source: FactSet, Bloomberg. As of June 28, 2011.

Elsewhere in Asia, there is potential for a change in direction in China. Recall that China has been tightening policies directed at property speculation and excessive lending since January 2010. Despite measures to slow the rate of money growth, inflation has picked up, providing adding pressure to pursue tight monetary policy.

Over the past month, we have come to believe the Chinese tightening cycle is in the late innings, as liquidity was tight, with both small businesses and property developers struggling to access capital. Despite the sharp clampdown on credit and economic slowing, growth remains healthy, at a 9.7% annual rate in the first quarter of 2011. The Chinese government sounds as though they are near completion of their task, with Premier Wen saying that measures targeting inflation “have worked.” Just as the slowdown was initiated by the Chinese government, who has many levers to slow inflation and excess growth, it can quickly reverse policy to reaccelerate growth. A soft landing in the Chinese economy is increasingly likely, with growth slowing and no crash. See more in Michelle’s article Bears and Bulls in the China Shop.

While inflation could still rise and additional tightening measures could still be implemented, the Chinese government has already begun to either implement or contemplate new stimulus measures, such as a new “cash for clunkers” program, policies to loosen credit for small businesses, provide relief on luxury goods import duties, and pilots to reform the pension system.

Positive reaction to possible end of Chinese tightening

Source: FactSet, Shanghai Stock Exchange, Standard & Poor’s. As of June 28, 2011.
* * Indexed to 100 as of June 28, 2010. A larger/smaller number above 1 denotes greater outperformance/underperformance of the Shanghai Composite Index relative to S&P 500 Index.

Local investors in China have taken notice, prompting a rise in the Shanghai Composite. The Chinese market is often viewed as a leading indicator, due to China’s rapid growth and large size. Rising Chinese stocks may be a sign that global growth is on the mend. With Japanese production coming back online and the boost to consumers’ pocketbooks from declining gasoline prices, we could finally witness a virtuous cycle of self-sustaining growth.

Lately, one of the most frequently asked questions I hear at client events is, “What keeps you up at night?” It reflects an at-times grave set of macro obstacles that the market has had to climb.

In fact, the vast majority of questions I’ve been getting at events are of the macro variety. Rarely am I asked about what companies are doing or saying, about corporate earnings, about the stock market’s short- or even longer-term fundamentals.

The macro remains top-of-mind, including:

• US debt ceiling deadline.
• Euro-zone debt crisis/Greek austerity.
• Impact of Japan’s disasters on global growth.
• Global soft patch/risk of a double-dip recession.
• China’s potential hard economic landing.
• Inflation risks.

One of the things I like to talk about at events is what could actually go right (and maybe already is). I am always most intrigued by the story no one is telling.

Today, that story would be a very positive one. I don’t write this with blinders on, but I want to lay out a realistic case for a better macro (and market) environment than many are expecting.

Déjà vu 
As you all know, much of what has been plaguing markets and confidence this spring/early summer is reminiscent of last summer’s economic soft patch. Other than the aftermath of Japan’s natural and nuclear disasters, the markets have faced similar pressures as last summer.

But at the same time, there has been meaningful improvement in most of the underlying fundamentals, as you can see in the table below.

Source: FactSet and ISI Group, as of July 1, 2011.

Earnings surprise potential 
Let’s hone in on corporate profits, which are 10% higher than they were at this point last year (see table above).

We are just now heading into the reporting season for 2011′s second-quarter earnings. According to Bloomberg, the S&P 500 is expected to post 13.3% year-over-year earnings growth in the second quarter, which is down from over 14% less than a month ago.

And there’s a lot of chatter that estimates haven’t come down enough to reflect the aforementioned economic soft patch (and margin pressure from previously elevated commodity prices).

ISI Group recently looked at the history of quarterly earnings relative to expectations and found that in the past 12 nonrecessionary quarters, analysts’ earnings estimates were too low 75% of the time by an average of 10.8 percentage points (see table below). All other factors aside, it would suggest that second-quarter S&P 500 earnings growth could actually be above 20%.

Source: Bloomberg and ISI Group, as of July 1, 2011. Expected EPS based on Bloomberg tally for the week prior to the start of earnings season. Red text indicates recessions.

During the past seven quarters, the stock prices of companies that beat earnings estimates outperformed the overall market by about 275 basis points over the ensuing six weeks. On the other hand, the stock prices of companies with earnings disappointments underperformed the overall market by about 400 basis points during the same period.

As for this year’s fourth quarter, Thomson Reuters First Call estimates that S&P 500 earnings will be up 17.7%, which would put earnings at $103 per share for the full year. That puts the price/earnings (P/E) ratio at only 13 times, below the historical mean of 17.

Micro story better than macro story
Another positive sign for the stock market is corporate equity issuance (or lack thereof). US corporations have amassed a nearly $2 trillion cash war chest, allowing them to go from huge sellers of stock at the market’s weakest point in 2009, to buyers and acquirers of stock in four of the five quarters through 2011′s first quarter.

According to a study by Ned Davis Research, when there is excessive net retirement of corporate equities, it’s generally good for the stock market.

Retirement is Good

Source: Ned Davis Research, Inc., as of March 31, 2011. (Further distribution prohibited without prior permission. Copyright 2011 Ned Davis Research, Inc. All rights reserved.)

Unless we’re wrong and the economy doesn’t exit the soft patch soon, US corporations are likely to be a positive factor for the supply and demand for equities.

Survey data supports this measure of optimism by corporations. A recent Business Roundtable survey of generally large company CEOs shows that 87% of them are optimistic, as you can see in the table below.

Source: Business Roundtable’s Second-Quarter 2011 CEO Economic Outlook Survey, as of June 14, 2011.

Indeed, that optimism weakened slightly versus the first quarter, but remains quite high in the face of so many macro obstacles. Again, it’s the positive micro story versus the negative macro story. One caveat, though: Smaller companies’ optimism, though improved, remains relatively weak.

Rally mode! 
The stock market may be onto something with its latest powerful rally. Some might suggest the market’s become overbought and, based on simple technical analysis, that’s true.

However, history shows that thrusts as positive as what we’ve seen recently tend to bode well for the market over the ensuing short-to-medium term.

During the rally, the 10-day advance/decline (A/D) line of the S&P 500 quickly moved from oversold in mid-June to extremely overbought as of last week’s close. As such, it’s one day away from making a new bull-market high.

According to Bespoke Investment Group (B.I.G.), since 1990, there have been 15 prior periods when the 10-day A/D had a similar positive reversal in the span of a month. Over the following month, the S&P 500 was up 80% of the time, with an average return of 2%.

In another sign of the strength of the rally, it was only the 10th time in the history of the S&P 500 that the index gained at least 0.75% for five straight days. According to SentimenTrader, after eight of the other nine times, buying the next day and holding for two weeks thereafter, resulted in gains.

That’s typical of extreme momentum moves: a short-term counter-reaction, then a longer-term move in the direction of the initial thrust.

It’s not just the US stock market that’s in rally mode. The majority of the key global markets have just moved back above their 50- and 200-day moving averages, suggesting that the global market trend is back in bullish territory.

July bucks “sell in May”
Finally, for what it’s worth, investors were reminded of the “sell in May and go away” phenomenon this year. For those not familiar with the adage, it reflects the typical weakness of the market in the half-year from May through October. However, one of the months that has historically bucked that trend is July—typically a strong month.

Weak consumer confidence good for stocks … huh? 
I want to transition back to the macro landscape now. Let’s take a look at what has been one of the stickiest of weak indicators—consumer confidence.

As you can see in the chart below, the Conference Board’s measure of Consumer Confidence hit an all-time low in March of 2009. It has since risen, but the latest dip puts it back in extreme pessimism territory—a territory in which it’s resided less than 15% of the time.

Weak Consumer Confidence Good for Stocks

Source: FactSet and The Conference Board, as of June 30, 2011.

Source: Ned Davis Research, Inc., as of February 28, 1969-June 30, 2011. (Further distribution prohibited without prior permission. Copyright 2011 Ned Davis Research, Inc. All rights reserved.) *Indicates current reading.

One might believe this would be by extension negative for the stock market. But much like investor sentiment, which works its contrarian magic on stocks, the same can be said for weak consumer confidence.

As you can see in the table above, the best performance for the stock market has historically come when consumer confidence was its weakest. Remember, consumers are generally reactive, while the stock market looks ahead.

Back to macro
Even some of the beleaguered macro story is getting sunnier.

Last week brought some much-needed good news:

• The Greek government passed its austerity package as a condition for further International Monetary Fund assistance, pushing potential default down the road.
• China’s Premier, Wen Jiabao, was quoted in the Financial Times as saying the tightening phase was coming to an end after a dozen hikes to its required reserve ratio, noting “growth in money and credit supply has returned to normal.” (China’s input prices in June were at the lowest level in 11 months.)
• Japan’s industrial production growth hit a 50-year high as production is coming back online more quickly than many expected after its disasters. (US auto production schedules are confirming strong growth for the third quarter.)
• The Chicago Purchasing Managers’ Index (PMI) and Institute for Supply Management Manufacturing Survey were both better than expected and the latter actually saved the global PMI from plunging.
• Core capital goods orders were strong again in May, highlighting the tax benefit of accelerated depreciation available until year end, when it’s set to expire.
• Although questionable as to rationale, the International Energy Agency decided to release oil from the Strategic Petroleum Reserve in order to boost supply and depress prices. It is also having the side-effect of pushing speculators out of long oil futures positions, which has been a reason for recently high prices of both crude oil and gasoline.
• Bank loans increased, bringing the positive trend to 13 weeks and counting.
• House prices appear to be starting a bottoming pattern.
• The Federal Reserve’s second round of quantitative easing (QE2), or buying back Treasuries, ended without the “bang” many had expected. And, although Treasury yields are up, stock prices and yields remain positively correlated.
• The latest Fed forecast, citing the record wide-output gap (spread between actual and potential gross domestic product), suggests the fed funds rate will stay near zero through next year.
• Cyclical stocks have been outperforming during the rally, signaling a better growth outlook.

Again, it’s intriguing to think about the story no one is telling. It might have a happy ending.

Important Disclosures

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 (or “informational”) purposes only and not intended to be reflective of results you can expect to achieve.

As you might expect, I’ve received lots of calls and e-mails asking what to do about the Greek crisis. So I thought I’d share my thoughts.

The first and most important point is that if you have a well-developed investment plan, it will have anticipated crises and incorporated that they’ll occur. During the financial crisis of 2008, I developed a talk titled “When Will Things Return to Normal?” The key point I made was that frequent crises were the norm. I showed that from 1973 through 2008, there had been at least 15 other crises. I also showed the evidence that stock returns weren’t normally distributed, and then point out that this is actually good news. The frequency of crises and the resulting bear markets (such as the three in that period with losses of about 50 percent) are why the equity risk premium is so large: Investors are risk averse and demand a large risk premium to accept the high volatility of investing in stocks.

I conclude the talk by noting that there are only three things we don’t know about bear markets:

• When they will occur
• How long they will last
• How deep they will be

In other words, we live in a world of uncertainty. And since there are no clear crystal balls, the investment plans we construct must anticipate that there will future crises. As Napoleon Bonaparte stated, “Most battles are won or lost [in the preparation stage] long before the first shot is fired.” That means we shouldn’t take more risk than we have the ability, willingness or need to take. Having a plan that anticipates severe bear markets gives you the greatest chance of staying disciplined and avoiding panic selling.

So, returning to the Greek situation. Yes, this crisis creates the potential for another financial “meltdown.” Because of the huge exposures of European banks to not only Greek debt, but also to the debt of the other PIGS (Portugal, Ireland and Spain), it’s possible that we could see a contagion spread across Europe, and financial markets could once again seize up as they did in 2008. If that were to occur, we would almost certainly see a flight to quality and liquidity, and the correlation of all risky assets (not just stocks) would likely rise towards one again. The potential for this occurring is why the Treasury bond market has defied Bill Gross’s forecast that rates were sure to rise.

The problem is that we don’t know what will happen. The crisis could be resolved, or we could see a default, the end of the Euro and who knows what. If your stomach is growling and you’re losing sleep worrying about the outcome, you likely either don’t have a well-developed plan or you were overconfident about your ability to deal with bad economic times. If the former is the case, then you should immediately develop a plan. If it’s the latter, you should probably rewrite your plan and permanently lower you equity allocation, because this likely won’t be the last crisis you’ll have to deal with.

In summary, investing in stocks is always risky. A well-developed plan, one that anticipates crises and takes appropriate risk, provides you with the greatest chance of achieving your goal. If you either don’t have a plan or take too much risk, the next crisis may cause you to sell and present you with a new set of problems. You won’t know when to get back in the market. There’s never an all-clear signal telling you when it’s safe to buy stocks. Never.

Remember that market timing is difficult because you have to get it right both times:

• When you sell
• When you buy

And the evidence from study after study shows that most investors get it wrong. They tend to sell (low) well after the bear has awoken from his hibernation, and they tend to buy (high) well after the bull has entered the arena. On the other hand, those who have plans that anticipate bear markets get to play Warren Buffett — they get to buy when there is blood on the street. They’re able to do this, because they’re adhering to their investment plan and need to rebalance.

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 
June 10, 2011

The stock market is correcting alongside disappointing economic data, with the indexes recently having their worst daily point drop in over a year. However, the levels are roughly equal to those seen in mid-April and still in positive territory for 2011. Meanwhile, yields on Treasuries have moved lower over the past two months, with the 10-year yield recently dipping below 3%, indicating at least some measure of risk avoidance returning.

One benefit has been investor sentiment—typically a contrary indicator—which had recently been in overly optimistic territory. Most sentiment indexes have now backed off and are at least in neutral if not in overly pessimistic territory (a positive for the stock market). We don’t believe that a rapid return to the uptrend in stocks that dominated the last two years is imminent, but rather continued choppy, sideways action appears likely to characterize the summer. Investors can take advantage of this as a base building phase and use it to make sure asset class allocations are in line with risk tolerances. And remember, it’s not just stocks that have risk. Fixed income also has features that can be detrimental to a portfolio. Should interest rates start to rise, which we believe they will, principle value will decrease, resulting in a possible loss should the instrument not be held to maturity. Having the appropriate balance of asset classes, with a long-term view in mind, is key to achieving financial goals.

Soft data—canary in a coal mine?
Recent economic data has been largely disappointing, but is it indicative of a larger, disturbing trend, or a soft spot in the overall recovery? We lean toward the latter. The Japanese earthquake, tsunami, and nuclear crisis dented global activity more than expected as supply chains were disrupted, especially in the auto and tech areas. Companies such as Toyota and Sony expect to be back to full-scale operations in the next month or so, setting up the potential for a second-half rebound. Additionally, some of the weather issues in the United States also had a likely-temporary detrimental affect on the economy as flooding in the Midwest and a violent tornado season slowed production and transportation. Again, as these issues recede, the potential for second-half upside surprises exist.

This doesn’t mean there aren’t remaining impediments to growth. Corporate confidence remains fragile as companies pulled back very quickly in response to higher oil prices and the aforementioned hits to growth. The Institute of Supply Management (ISM) Manufacturing Index remained in expansion territory, but dropped precipitously from 60.4 to 53.5—the lowest level since September 2009. More concerning, new orders fell 10.7 points to 51.0, barely in expansion territory, while employment dipped 4.5 points. However, lending support to the temporary weakness argument, the ISM Non-Manufacturing (services) Index improved to 54.6 from 52.8, with employment gaining 2.1 points and new orders growing by 4.1 points. The factors mentioned above are largely on the manufacturing side of the ledger, and the better services report helps to support that view. 

Service sector moves past manufacturing

Source: FactSet, Institute for Supply Management. As of June 7, 2011.

The fragility of corporate confidence is probably best illustrated in the jobs market.  After a string of disappointing initial unemployment claims numbers that resulted in the four-week moving average moving back above 400,000 again, we saw the ADP private employment report post a very disappointing 38,000 job gain, while the more comprehensive labor report showed a meager 54,000 gain, while the unemployment rate rose to 9.1%. 

Weak jobs growth remains the largest risk to our belief in a renewed rally.  Should confidence not rise among executives, it’s difficult to see the hiring environment improve substantially.  We are also looking at investor confidence in the corporate community as it all ties together.  We’ve seen the spread on junk bonds creep higher, indicating some measure of increasing doubt—not overly concerning yet, but important to watch.

Junk spreads indicate waning confidence

Source: FactSet, Federal Reserve, Moody’s. As of June 7, 2011.
* equals high yield bond yield less 10-yr Treasury yield.

Of course, no discussion of disappointing data would be complete without mentioning the housing market. After a string of poor data culminating with another decline in the S&P Case-Shiller Index pricing data, headlines touted the fact that we are now in a “double dip” housing recession. While the lack of even modest improvement is starting to concern us more, several factors are important to note. First, housing is very regional, with the major areas of weakness concentrated in a few areas such as California, Florida, and Nevada; so it’s somewhat difficult to make a broad, nationwide statement on housing. Additionally, housing affordability remains near record highs. There’s little doubt the weather issues mentioned above dented demand and activity, but we need to start to see at least some signs of improvement to become more confident in the second half.

Fed speculation on the rise
Due to the weakness, market commentators were quick to bring up the possibility of a new round of quantitative easing (QE3) possible after QE2 concludes at the end of June. While certainly not completely off the table, Bernanke has noted that the bar for such action is very high, and we believe it’s highly unlikely at this point in time. The Fed will need to see sustained weak data before it acts again, although this current soft patch virtually assures they will maintain the size of their balance sheet until things start to improve again.

We also believe the Fed is watching the fiscal situation as states and cities cut spending, while the Federal government is discussing its own round of spending cuts. The removal of government spending stimulus may drag on the economy in the short term, but the net result of deficit reduction would likely be cheered by markets over the longer term. Of course, the current headlines continue to revolve around the debate over raising the debt ceiling. We believe Congress will take the debate up to the deadline, possibly causing some short-term volatility in the fixed income market, but that the United States will not default on its debt and a deal will get done.

Global synchronized slowing
Signs of slowing economic growth are not exclusive to the United States.  

Slowing in sync

Source: FactSet, Institute of Supply Mgmt., Nat’l Bureau of Statistics of Cina, Bloomberg. As of June 7, 2011.

As noted above, increases in oil prices have a particularly large impact in the United States, where the translation from oil prices to gasoline prices is high. This is due to the smaller tax as a percentage of the total price relative to global norms, and because consumers are nearly 70% of the economy, one of the largest percentages globally, while gasoline consumption per person is high.

As for the eurozone, growth tends to follow the US economy with a lag, and a combination of slower US growth, fiscal austerity, bank lending hampered by the need to recapitalize to cover risks from the sovereign debt crisis, and a central bank with a bias toward tightening will hamper economic growth. However, the eurozone has not been much of a contributor to global growth in recent history.

The three largest swing factors for economic growth globally are the US consumer, Japanese manufacturing output, and Chinese construction of property and infrastructure. As such, the simultaneous slowdown on all three areas has affected growth.

How temporary is the global slowdown?
While Japan is likely to continue to be weighed down by consumption restraint, electricity shortages, and a government lacking leadership and decisiveness on a reconstruction plan, the recovery in Japanese manufacturing has begun. An industry survey by Ward’s shows that after a decline in US automotive production in the second quarter, it is expected to spike higher in the third quarter, to a higher annual rate than any quarter in over a year, and Japan is an important cog in the automotive supply chain.

China’s economy is moderating and measures put in place to slow lending and property speculation have made a significant impact. Credit is tight, with many small businesses having difficulty getting financing and reports that property developers have had to pay interest rates above 30% in non-bank channels for loans. Property sales have slumped and as a result government land sales to developers have significantly dropped off. Land sales constitute 70% of local government revenues according to HSBC, and the pain on their budgets may be unsustainable for a long period without other changes.

These factors indicate the tightening cycle in China is likely in the late innings and we don’t believe there will be a hard landing. But growth that is not fast enough to create jobs could threaten social unrest. The slowdown was initiated by the Chinese government, who has many levers to reaccelerate growth, and due to the centralized structure could quickly switch policy as the year progresses.

As for gasoline prices, the outlook is less clear. The impact of rising prices on consumer behavior is typically heavily influenced by the pace of change, but still-slow wage growth and actions to repair balance sheets by consumers in developed nations means having a limit to the rise in prices tolerated before reducing demand and cutting spending elsewhere. This self-correcting mechanism, where higher prices ultimately results in lower demand could place a near-term peak on oil prices.

Emerging market oil consumption share growing

Source: FactSet, BP Statistical Review of World Energy. As of Dec. 31, 2010.

However, emerging countries now account for more oil consumption than developed nations, and their oil consumption per person is still small relative to developed countries. While a return of Libyan production could result in a sharp short-term decline in prices, the Energy Information Administration believes a tight oil supply environment will persist through 2012; and there is the possibility that oil prices may have more upside than downside potential over the medium term.

Altogether, the slowdown this year comes from an improved position relative to last year and we believe global growth could reaccelerate from the low levels of the first half of 2011.

What is the outlook for international stocks?
There is a strong connection between economic growth and earnings growth, but for stock market performance, it is often the rate of change that matters, not the level of growth. As growth downshifted, stocks have struggled.

We are more positively inclined to stock markets where sentiment is pessimistic and there is the potential for growth to surprise to the upside. Chinese and Japanese stocks tend to outperform when during times of slowing, as investors flock to China when growth is scarce; and low expectations for Japan provide less potential for downside surprise. While we believe the Chinese economy is likely to slow further from here, we are looking to get more positive on the Chinese stock market as the bears likely get louder.

As for Japan, we would like to see a change in government approach away from conservatism, indecision and political feuding, toward a more clear vision and plan for reconstruction. However, it is possible Japanese companies begin to make changes to become more competitive ahead of the government moving ahead with reconstruction plans. Absent a prolonged recession in Japan, Japanese stocks may have more upside than downside from here.

Lastly, on a relative basis, we are positively inclined to the Canadian stock market. The S&P/TSX Index has a high weight in energy and materials, at 26% and 22%, respectively, and we believe oil prices may have more upside potential than downside potential after the recent correction. Unlike commodity-oriented Australia, which is tied to growth in China and Japan, with exports at roughly 25% and 20% respectively, Canada is tied to growth in the United States, at over 70% of exports. Despite a slowdown in growth, we believe the outlook for the US economy potentially has less variability than in China and Japan. Also, Canada’s economy has continued to post strong growth, at 3.9% in the first quarter, and the potential for rate hikes gives US investors an added performance boost, because the US dollar is likely to weaken relative to the Canadian dollar.