Risky Investments Aren’t as Risky as They Appear in Those News Reports

With the nonstop drum beat of negative, provocative and just downright scary news coverage it is totally understandable that markets are skittish and volatile. When one stops and drills down through the noise, political demagoguery on both sides of the aisle and inflammatory headlines, the weight of the evidence does not support an Armageddon scenario. In fact, things are actually pretty good.

Like a hand-wringing worry wart, the markets have been pivoting from one crisis to another since early summer. The “experts” who have almost unanimously been unrelentingly pessimistic, have turned out to be very wrong (at least so far). In fact, nothing that the punditry cited as cautionary this year has actually materialized as a real threat:

Fukashima reactor widespread radioactive contamination
Disorderly European sovereign debt defaults
US Default –Debt ceiling debate
Dissolution of the EU / Euro
US Debt downgrade disruptions
US double dip recession

None of these headline-grabbing disasters actually have happened and we believe that they will not. But, as we have said many times: Just because there was not an actual fire in the theatre does not mean you don’t get trampled in the panicky rush to the exits!

Unfortunately, since emotional reactions cannot be measured or accurately predicted, as advisors we have to stick with what can be measured. Measurable items include company valuations and economic data. Based on these data, although you would never know it listening to the media, the case for risk investments like stocks, lower quality bonds, real estate and raw materials continues to be compelling. Here’s why:

Stocks are cheap. Today’s valuations are well below historical averages and imply that stocks are undervalued based on a number of metrics. We have just seen the strongest earnings season in history. S&P 500 earnings are at historic highs yet the index is still below its October 2007 all-time high of 1546.50.
After inflation, GDP has grown for nine consecutive quarters at an average rate of 2.5% and in our view had we not had the Japanese earthquake and tsunami, it would be at least ½ point higher. US output as measured by GDP is now higher than at any time in the country’s history.
Third quarter GDP growth was 2.5% led by capital expenditures by companies, mostly on equipment, primarily transportation related as well as software and peripherals. The rate of growth in this area has been significantly greater than overall GDP. Would companies be making billions in Cap-Ex investments if the world is going to end?
Many are surprised to learn that consumer spending is up nicely as well, led by household durable goods. That is, washing machines, microwaves, refrigerators and so on. This type of spending is essentially back to its all-time high levels reached in 2007. Remember: Consumer sentiment and consumer behavior are two different things.
This activity has occurred despite a very sick housing market. Our view is that housing has bottomed and if not, it is hard to fall out of the basement window, so any downside is limited.
We do not believe that disorderly defaults in Europe are likely. Restructuring is the outcome we see and, frankly the preliminary indication on austerity measures by troubled countries is something we can only hope for in the US. Contagion, which is a massive loss of confidence in the financial system, is always a possibility but we are optimistic that it will be contained. Remember: In the 1980’s almost every major country in our hemisphere defaulted on its debt, the exceptions were the US and Canada, Columbia, El Salvador and Guatemala. Despite this the market was up significantly in every year where defaults occurred except 1981. Currently, the largest US banks have about $50 billion in exposure (assuming a 100% default) and currently have between 700 and 800 billion in capital.
We believe that a slowdown in Europe is possible and in China it is probable, but the impact on the US will be negligible. US exports to both markets are a low single digit percent of GDP, which would still grow even if things were very bad in both regions.
Failure to reach budget compromise is likely and by the time you read this the Super Committee will probably have “punted”. This issue was designed from the beginning to fail and any decisions postponed until after the 2012 elections. Market expectations are low and this is unlikely to be an issue either.

In the final analysis, we believe that there is a lot to be optimistic about if one drills down and looks at the facts. Of course there is still risk, but there is ALWAYS risk. Although there can be no guarantees, historically the tradeoff for this uncertainty has been pretty good long term returns from a diversified portfolio containing stocks, hard assets, bonds and cash equivalents.

All Investing involves risk including the potential loss of principal. No investment strategy such as diversification can guarantee a profit or protect against loss in periods of declining values. Past performance is no guarantee of future results. Indexes cannot be invested in directly, are unmanaged and do not incur management fees, costs and expenses. Be sure to speak to a qualified financial advisor before considering changes to your investment strategy.

As seen in the 12/23/2011 issue of Washington Business Journal

December 23, 2011