A financial tug-of-war
As we head towards the end of the year, there continues to be a daily tug-of-war between the negative headlines emanating from Europe and the improving economic data in the United States. On any given day, the markets are reacting violently in one direction or the other and price swings of 100 to 300 points are becoming the norm, not the exception.
After rebounding 11 percent in October, the stock market has taken a turn downward. Credit spreads in November have dramatically widened on Italian and Spanish debt, which has increased the likelihood that these two countries will need a bail out too. Even France’s AAA credit rating is under attack. The only way to alleviate this crisis is for the European Central Bank and German Chancellor Merkel to come up with a credible game plan that halts euro zone bond yields from rising above the rubicon seven percent level.
Because of Europe’s troubles, investors are ignoring the good news from corporate America and the improving U.S. economy. The S&P 500 earnings for third quarter were 17 percent above last year and should come in at an average of $25.43 a share, which marks the eleventh consecutive quarterly increase since the first quarter of 2009.
A number of multi-national U.S. companies continue to significantly increase their dividends. In the last two months alone, McDonald’s, Microsoft, Home Depot, and Nike have all raised their dividends 15 percent or more. I seriously doubt management would do this if they were worried about a double dip recession. In many instances, investment grade corporate bonds yield less than the dividends paid by the same company. Auto sales, retail sales, and consumer confidence have improved. Even jobless claims, home sales, and unemployment numbers are a little better than a year ago.
Unfortunately, the Super Committee kicked the deficit reduction problem down the road and this failure will potentially trigger massive cuts to defense spending and Medicare in 2013. Sadly, Congress continues to be more concerned about getting re-elected than doing what is best for the country by adopting the plan put forth by the Bowles-Simpson Commission. It now appears that no progress will be made on the deficit before 2013 and quite possibly 2014. As a result, the 2 percent payroll tax reduction and jobless benefits may not be extended and if this doesn’t happen, consumer spending will be hurt going into 2012.
Another logical outcome of this continued dysfunction in Washington: the expiration of the Bush tax cuts and an increase in the capital gains tax rate to 20 percent. I also expect that the automatic $1.2 trillion in defense and Medicare cuts will be implemented. Quite frankly, this may be the only way Congress will be able to cut the budget deficit – by doing nothing.
How all this impacts the stock market in the short term is very hard to predict, but we continue to recommend collecting as much dividend and interest income from your portfolios as prudently possible. With yields on the 10-year U.S. Treasury bond around 2 percent, stocks are very cheap historically and with the recent sell off in the market, we are finding great companies to invest in that yield well above 3 percent.
You may have read recently that Warren Buffet is buying shares in IBM, Intel, and even adding to his Wells Fargo position. He doesn’t know how the crisis in Europe gets resolved, but he is investing in corporate America, and so are we.