Most of the pundits had expected a relief rally in stocks following a resolution to the debt ceiling crisis.
That did not happen.
Despite a last-minute agreement by Congress on Sunday night, which averted default and possibly a ratings downgrade as well, stocks fell sharply over the first two days of the week. As I write, the S&P 500 is down over 4% since Friday's close, and the index is now down for the year. So what gives? Why is the market behaving so poorly despite the hard-fought compromise by lawmakers?
The answer lies in the economic data. Over the past week we have received data point after data point that suggest the economy is inching dangerously close to recessionary territory. While most economists still believe we will avoid another recession, these same economists also agree that such weak economic growth leaves us much too susceptible to an unforeseen negative shock to the economy. This shock could come in the form of anything from a slowdown in China to a terrorist attack anywhere in the world to another flair up in the Middle East (causing oil prices to spike).
So let's review the new data we have received over the course of the past week.
Looking ahead, Friday's jobs report will be the next very important piece to the economic puzzle. This morning's ADP estimate (+114K jobs in July) may have provided some comfort to those worried about Friday's government report. But while 114K jobs is nothing to sneeze at, that level of job growth is still not enough to keep up with the projected growth in the labor force and bring down the unemployment rate. In any case, another report from Challenger, Gray and Christmas this morning said that employers announced the largest number of job cuts in July in 16 months. Companies in a wide variety of industries have announced job cuts recently. These companies include Merck (up to 13K), Goldman Sachs (1K), UBS (5K), Barclay's (3K), Border's (10.7K), HSBC (up to 30K), Cisco Systems (6.5K), Boston Scientific (up to 1.4K), Research in Motion (2K), Gannett (700) and Lockheed Martin (6.5K). State and local governments also continue to shed workers as they struggle with budget deficits.
There are a couple questions any investor must ask given the environment we are now faced with. First, how much longer can corporate profits remain strong in an environment of 1-2% (or lower) GDP growth. It is true that corporate profits have been very strong in spite of the sub-par economic recovery. Strong earnings growth has been a function of cost-cutting (including job cuts), strong sales growth in emerging markets (aided by a weak dollar), and reserve releases at banks. But are these sustainable sources of earnings growth? We would posit that earnings growth going forward will be more a function of top-line growth, and the prospects for top-line growth do not look at that promising. Do estimates need to come down?
The second question to ask is: Could QE3 now be on the table? And if so, would the announcement of a third round of bond-buying by the Fed be enough to lift stocks from the doldrums yet again? Unfortunately, today's investing environment requires not only a good feel for the economy, but also a good feel for how government officials will react to economic indicators. Our long-held opinion has been that the recovery has been highly dependent on government intervention. If the government (and the Fed) are less likely to be as aggressive going forward, what does this mean for stocks?
These are the questions that keep us up at night. It is worth noting that we are in roughly the same predicament we were in one year ago, when similar anxiety about the economy led to the announcement of QE2 in early November. It begs the question: How many times can the Fed keep stepping in to support the stock market? For now, we remain defensive and heavily invested in high-quality, blue chip stocks with strong balance sheets and attractive dividend yields. Many of these stocks are looking increasingly attractive in light of the 2.62% available from the 10-year Treasury note.
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.