Has our society gone bipolar? As I understand it, people who suffer from manic depression, now called bipolar disorder, experience episodes of extreme mood swings from clinical depression to extreme elation. In the most serious cases it is all extremes, there is nothing in the middle.
I think this describes our societal situation pretty well. It certainly seems true in politics; it even seems true in sports. Rory McIlroy makes history winning the U.S. Open with a record-low score, and immediately the golf pundits ask whether he will be the next Tiger or a flash-in-the-pan flop. Evidently those are the only choices. Why can’t we just enjoy the moment for what it is?
Of course it is most true in the financial markets. It starts with economic forecasts. In my twenty years in this profession I have never seen forecasts change so often and so dramatically. Release two good pieces of data and suddenly the recovery is right around the corner and the market is up – the S&P rose over 6.68 percent in the last eight business days of June. One bad report and we are headed for a double-dip; we have lost over two percent already in July. What has actually occurred is that our economy is sluggishly growing at around two percent. This is what two percent growth looks like: mixed economic reports with the only constant being no real jobs growth.
What is really maddening about this market bipolar disorder is that, just like the real disorder, reason has gone out the window. Let’s look at the last two days: the big economic story on the Sunday news shows was the debt ceiling debate in Washington. Our Treasury secretary was making the rounds, letting everyone know that the U.S. will default on its debt on August 2 if a deal is not reached. Many believe this itself is an exaggeration, but for the sake of argument let’s take Mr. Geithner at his word. How should the market react if the U.S. is going to default on its debt?
I would assume that there would be a massive sell-off in Treasuries and interest rates would go through the roof. I would assume a short-term panic in the stock market because that is what people do, but no real long-term impact, since people would continue to drink Coca-Cola, shop at Wal-Mart, and get on the iPad to keep track of the government meltdown, and ultimately realize investing in some of these companies makes sense. This is because I seem to be suffering from this attack of reality: I still believe that Treasuries are the debt obligation of the U.S. Government – the guys who are going to default on August 2 – and that stock represents partial ownership in privately run corporations, who are not going into default on August 2.
So what did happen Monday? Stocks were down around two percent and Treasuries were up. That is correct, they were up.
This may because our friends on the other side of the pond are actually headed for default, while no one seems to believe Mr. Geithner. Therefore, threats aside, the investing world still trusts U.S. Treasuries, at least more than they trust European debt. However, that leads us to yesterday. The big fear now is that Italy is going to follow Greece into default. It makes sense for anyone who studied Western Civilization. The Roman Empire followed the Greek Empire; certainly they would follow each other in the never-ending debt crisis. The world markets were down dramatically because of the fear of Italy’s default. Then, Italy announced that they had a “successful” auction of one-year notes. The interest rate at which they finally sold was 3.67 percent, up from 2.147 percent in June, and they barely got them all sold. This “good” news sent the Italian market, which was down 4.8 percent at the time, on a tear. Their market closed up 1.17 percent – an almost six percent jump because interest rates had only gone up 1.5 percent in a matter of three weeks? Bipolar is the only explanation.
The primary symptom in the market bipolar syndrome is that there is only one trade to make. It is the “risk-on, risk-off” trade. When the bad news comes we pile into Treasuries, even if the bad news is that Treasuries are going to default. When the good news comes we pile into the same stocks that have been doing well over the past year – small caps, energy and materials – even if the P/E on small caps is 30 and the commodity bubble shows signs of collapsing. One of the things I love about my job is that every time I think I have finally seen it all, they come up with some brand new kind of insanity.
The silver lining in all of this is that volatility does bring about opportunities for those of us who are investing for time horizons measured in years and not minutes. The S&P 500 is selling at 13 times forward earnings, and certain sectors, such as large-cap technology, look very attractive. There may be some short-term pain, but when companies like Cisco are selling at 8.67 times earnings when adjusted for their net cash position, it is hard to see how you won’t make money in the next year or two.
Reality is usually in the middle. Unless there is a dramatic change of course from the policies of the last decade, our economy will continue to grow at a very European rate of two percent, not at normal U.S. growth standards, but not a depression either. Rory McIlroy will most probably be a solid Hall of Fame golfer, but neither another Tiger Woods nor a flash in the pan. Most importantly for us, Treasuries will most likely deliver the three percent return their yield indicates, and stocks will likely grow at the approximately ten percent their earnings yield is indicating. We will see neither a boom nor a collapse in the long run.
In the meantime, the market never ceases to entertain. I love my job.
Chuck Osborne, CFA
Managing Director
