It’s the Politicians, Stupid

10/21/2011 10:00 am EST

Focus: MARKETS

James Stack

President, Stack Financial Management

Washington pundits couldn’t have done a better job of pulling the carpet out from under the feet of an already-fragile economic recovery, says Jim Stack of InvesTech Research.

The “political brinksmanship” in Congress during the July debt-limit showdown sent consumer expectations on a downward spiral that rivaled the sudden loss of confidence when Iraq invaded Kuwait in 1990.

And threats from the President that Social Security checks might not be mailed out on August 1 if an agreement wasn’t reached sent fears directly into every retiree’s pocketbook. In addition, numerous politicians’ warnings of the dire consequences (of not raising the debt limit) on daily morning news programs made absolutely sure that no one could escape the cloud of impending doom.

The sad fact that actual default on US debt was never a real risk, or that an agreement was ultimately reached, obviously couldn’t undo the widespread damage that was already done to confidence.

This month started off with Senate Majority Leader Harry Reid again “threatening to shutter government over a disaster aid dispute.” And the Federal Reserve’s monthly press release contained ill-conceived wording that destabilized (rather than calmed) the financial markets: “Moreover, there are significant downside risks to the economic outlook, including strains in global financial markets.”

The DJIA tumbled 700 points in 24 hours—leaving Ben Bernanke’s attempts to further stimulate the economy with his $400 billion “Operation Twist” program (trading short-term for long-term Treasuries to lower mortgage and borrowing costs) twisting in the wind.

What is it that these political idiots (sorry, I mean pundits) don’t get?

If the current crisis lies in confidence, you don’t intentionally —or even accidentally— destroy what confidence is left.

The Fundamental Facts…
With an engineering background, I am first and foremost a technical analyst of the market. However, that is blended with many years of experience as a market historian, plus a healthy respect for fundamental facts.

Let me step over to several historical and fundamental observations that are important to our investment strategy at this point in time. If we were heading for a true financial Armageddon in the US debt markets, we would not be seeing the US dollar soaring in response. The greenback still remains the safe-haven currency of choice when global economic fears suddenly start to escalate.

The second historical observation —which may fly in the face of the doom-and-gloom crowd— is that blue-chip US companies may not be such a bad place to be invested in the event of a worst-case scenario (as unlikely as that scenario may be).

What is the worst-case scenario? It would likely occur if the US economy dropped back into recession, causing deficits to soar, and eventually triggering a crisis in the dollar (similar to Greece).

But if that worst-case scenario did occur, then a falling dollar would be offset by sharp increases in the value of underlying hard asset prices…including gold, commodities, and yes—even blue-chip stocks. While earnings fall in a recession, many of these multinational companies do not lose their underlying fundamental earnings capacity.

There are far worse assets to ride through the worst-case scenario with, including bonds. And the last historical observation is that current fundamental values on Wall Street are at levels that—at any other non-crisis point in time—would be considered extraordinarily attractive. The only time when the earnings yield on the S&P 500 was higher than today is when short-term interest rates were at 5%-plus.

Instead, short-term rates now sit at 0%, and it’s pretty darn easy to step out and find solid blue-chip companies yielding 3.5%, or nearly twice the yield of a ten-year Treasury bond.

Who would imagine that Microsoft (MSFT)—a technology stock!—would raise their dividend yield this week to nearly 3%, a 25% increase? Excluding a hefty $4.75 per share in cash reserve, Microsoft is selling at a P/E ratio of only 7.9!

Apple (AAPL) may be the “darling” of Wall Street due to iPhone and iPad sales, but Microsoft still controls 87% of the operating-system market. And the company’s demise has been greatly exaggerated, since annual revenues over the past ten years (including the most recent 12 months) have increased at over 10% per year.

The point is that we believe this is indicative of the underlying attractive valuations that exist today—particularly if the “worst-case economic scenario” is not the true outcome.

S&P companies obviously feel likewise, as stock buybacks increased 41% in the second quarter of this year. Cash holdings on corporate balance sheets are sitting near $1 trillion ($976 billion) today.

Strategy
While the technical breakdown has forced us to move to a more defensive allocation (77%), and may trigger additional reduction if weakness continues, we hesitate to adopt an extreme cash position, like we have at times in the past, due to the above underlying fundamentals.

One fact is certain. Once the loss of confidence starts to reverse —for whatever reason— the stock market will be the prime beneficiary, as investors recognize the underlying values.

And if the double-dip recession fails to appear, then the next six to nine months could provide some of the most spectacular upside gains that we’ve seen in this bull market.

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