For most of the past year the stock market waged a battle over impressive corporate profits versus grim macro-economic conditions. The bulls were winning until late in the summer when the fragility of high-income economies became apparent. The catalyst was the realization that the recovery in global manufacturing, including emerging markets, was grinding to a halt.

The root of the problem is too much debt which cannot be solved quickly and needs effective leadership, a quality in short supply in rich-world countries. Until recently investors looked to the Fed to fix things. However, like the man behind the curtain in the Wizard of Oz it is now clear that the claims about the Fed’s power were greatly exaggerated. Unfortunately the fate of the economy and stock market will be determined by the ability of policymakers to solve the difficult problems. We probably shouldn’t be too hard on our elected officials because even the “experts” can’t agree on the right prescription to heal our economic woes.

However, the good news is that our problems are solvable. The Eurozone as a whole is solvent so long as the core countries stand behind the peripheral weaker countries. In the U.S. even modest changes to social security, Medicare, our tax system, and discretionary spending can go a long way to controlling our debt and deficits.

In addition to the negative effects of deleveraging our economy is struggling due to a lack of real income growth. According to the Census Bureau, many U.S. households have sustained stagnate incomes for a generation.  As reported in The Economist, “(i)n 2010, the typical American household earned an inflation-adjusted income of $49,445, scarcely different from that in 1989 and a fall of 2.3% since 2009. Current incomes are at roughly the level of the late 1970s for those near the bottom of the income spectrum.”  (See chart below)

On a positive note while consumers in the developed markets will be constrained emerging market consumers are getting richer. Only U.S. consumers outspent those in China, and by 2013 the Economist Intelligence Unit expects China to overtake the U.S. as the world's largest retail market.

The biggest near-term risk is that the debt crisis in Europe spins out of control and causes another financial crisis. Since this risk is so serious we are maintaining a very conservative posture. Furthermore we expect earnings expectations to come down and for investors to apply a low earnings multiple to stock valuations.  But keep in mind that a lot of damage has already taken place (European, Emerging Market and U.S. small-cap stocks all fell about 22% last quarter), and if prices of financial assets become too cheap, the "animal spirits" of both investors and companies will reawaken.

Despite our macro concerns there are opportunities in the stock market, especially in the mega-cap arena where valuations are attractive and yields are high. Best of all, we are not taking balance sheet risk as our companies have very little or no debt. Investors are in a unique period of time where they can own very high-quality stocks and generate a sustainable and growing income stream well above money markets and medium term U.S. Treasury securities. High-quality stocks have started to outperform after being ignored over the past decade. We believe this asset class is underrepresented in institutional portfolios and will benefit as this group rediscovers the value in this area.

(c) Tillar-Wenstrup Advisors

www.twadvisors.com

         
 

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