Farr: Europe’s a Mess and the Fed Is On Hold

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The stock marketappears to be taking a well-deserved breather after a double digit first quarter 2012 return. Volatility has increased recently and we find ourselves back nearly where we started the month. We continue to see a disconnect between corporate earnings (very strong) and U.S. economic data(getting better but still not great).

Through yesterday (Wednesday), over 80 percent of the companies that had reported in the S&P 500had reported quarterly results that exceeded expectations. Despite these strong numbers out of U.S. corporations, it is not surprising to see the market level off given the strong 1Q12 showing and the concerns about Europe that seem to once again be rising to the surface.

Should one “sell in May and go away” as the Wall Street saying goes? This strategy would have been a profitable one in 2010 and 2011. Though there are many negatives on the horizon, Farr, Miller & Washington doesn’t try to time the market. Client assets are invested with a long-term time horizon and portfolios are designed to weather whatever storm might suddenly pop up. Still, there are several different areas that we are monitoring closely as we manage our client portfolios.

First, Europe remains in the news. The ECB’s decision to pump liquidity into the European banks appears to have staved off a European credit crisis. This is a huge positive and a major reason that the stock market has acted so well over the past couple of quarters. However, European countries remain saddled with too much debt while growth prospects remain scant. Here are a couple of items in the news that bear watching as the year progresses:

o The French have their second round of presidential elections on May the 6th and it looks like they will elect Francois Hollande. He is a representative of the French Socialist Party. What we are seeing in France is a sort of gravitation toward less austerity. Generally speaking, no one in France wants to tighten down the economy too much.

o The Dutch government has collapsed due to budget disagreements and voter dissatisfaction with too much austerity.

The French and Dutch situations in turn create problems for the entire European Union. Germany, currently the strongest player in the EU, is still calling the shots for the EU as a whole. This has allowed them to push for necessary austerity and other changes.

But Germany’s domination of the EU has relied upon a generally collegial group of member countries who are willing to follow and support the German lead. To the extent that they have all been singing from the same song sheet, markets have found strength and sustenance and have recovered in timely ways. This collegiality appears to be disappearing.

Second, the Federal Reserve’s actions continue to warrant a great deal of attention. After all, the Fed’s decision to lever its balance sheet in order to stimulate the economy has been one of the driving forces of the higher stock market and paltry bond yields.

Can we expect more quantitative easing or is it time for the Fed to tighten? For now, it appears that the Fed is content to stay on hold. The U.S. economic situation is now forecast to be a little brighter than was perhaps expected earlier in the year but unemployment remains stubbornly high. The Fed has made it clear that it believes that inflation is under control and that it can keep monetary conditions loose for the foreseeable future.

We continue to believe that the Fed would step in with more easing if the economy began to roll over again. Mr. Bernanke remarked yesterday that, “we remain prepared to do more, as needed, to make sure that this recovery continues, and that inflation stays close to target.” So while he said the punch bowl may not be forthcoming, it may not disappear entirely. We aren’t sure how many more times the Fed can step in or exactly how all of this easing will ultimately be unwound but these are topics that bear close monitoring if this recovery continues to strengthen.

Third, this year end brings an election in the US in November, another Congressional vote on the US debt ceiling, and we have tax cuts expiring. Lots of things could happen in this particular lame duck session. I’m going to go ahead and posit that this will be the most important lame duck session of Congress that we’ve seen in perhaps the last 50 years; there are several critical issues that have been kicked down the road for about as long as possible. These issues come to roost in early November.

We continue to own companies that have very solid balance sheets, strong cash flow, low levels of debt, really good management, expanding market share and are growing their bottom line. We think this offers protection through whatever the market may bring. And even though we may not sell in May, we remain confident that our portfolios are solidly positioned to weather whatever happens. And even though we didn’t sell last May, we’re higher than we were last May, and the S&P 500 is indeed higher.

We have to stay the course; there are lots of things in motion. Pay close attention and keep that sharp ear out for what happens next out of Europe. We’ll get this together.

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Michael K. Farr is President and majority owner of investment management firm Farr, Miller & Washington, LLC in Washington, D.C. Mr. Farr is a Contributor for CNBC television, and he is quoted regularly in the Wall Street Journal, Businessweek, USA Today, and many other publications. He has been in the investment business for over twenty years.