Stock markets dropped sharply around the world during the third quarter, as tighter monetary policy combined with a failure to resolve the European sovereign debt crisis, resulting in fears of a 2008-style financial panic and a global recession. Debate over whether the rout technically qualified as a bear market seemed moot among the carnage, which saw domestic large cap stocks as global leaders, declining less than 15%, compared to international stocks, which dropped 19%. As one got closer to the source of the crisis, returns worsened, with the MSCI Europe Index dropping 23% and the even more directly exposed Euro-Country Index plunging more than 28%. At ground zero, the Greek stock market almost halved.

Despite the litany of problems in the U.S., rising anxiety and widening credit spreads resulted in a flight to “quality”. The U.S. dollar suddenly didn’t seem so bad, compared to the alternatives, and larger, more stable companies outperformed smaller, more speculative shares. Reflecting the swift shift in psychology from inflationary monetary policy to deflationary credit crisis, most commodities dropped sharply. Although gold’s safe haven status allowed it to rise in price, copper, a classic economic bellwether, fell 26% and Brent crude retreated 9%.

Fire in the Theater
In the 1980’s, an asset allocation concept called Portfolio Insurance quickly arose, drove the stock market higher, despite deteriorating fundamentals, and then spectacularly failed, simultaneously helping create and being invalidated by the crash of 1987. Without repeating the mechanics of Portfolio Insurance, its key flaw was the requirement that its “policyholders” all sell the market at once to reduce their exposure. Like panic in a theater, a race for the exit by one or two patrons might work, but be disastrous for the assemblage.

Today, those nervous patrons are the hedge funds. Although composed of many different strategies across different asset classes, a large percentage is deeply averse to negative returns, even on a monthly basis. Benchmarked against cash rather than a passive equity index, their game is absolute, not relative performance. This means that while they may like a stock in which they are invested, should its price begin to decline, they may reduce or sell their position. Like moviegoers at a blockbuster, but suffering from ADHD, they are continuously looking over their shoulder to see if anyone is headed for the door. Often unable to tell the difference between disinterest in the movie and a need for more popcorn, they will run for the lobby, distorting the stock price. When fear of systemic risk rises, the equivalent is a run for the lobby across the theater chain, making for extreme individual stock and collective market volatility.

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The Widow’s Walk
Three months ago, many economists expressed optimism on the outlook for the U.S. economy. They overwhelmingly subscribed to the “stock” theory of Quantitative Easing, believing that just holding the previously purchased treasuries provided stimulus. They anticipated a surge in third quarter GDP, based on a recovery in auto production following the repair of the earthquake-damaged Japanese supply chain. And predominately being Keynesians, they believed that more fiscal stimulus (read larger deficits) would be better than moving towards a balanced budget.

Three months later, the mood has turned decidedly bearish, with many economists cutting U.S. and global GDP forecasts and more than a few anticipating a European recession. Higher inflation in the U.S., Germany and many emerging markets has painted central banks into a corner and unsustainable fiscal deficits mean that net government spending will be lower over the next several years. The debt crisis in Europe and political class-warfare in the U.S. help ensure that businesses sit on the sidelines, wary of economic and political risks despite having high profits and strong balance sheets that could be used for new investment.

In their role as leading indicators, declining stock and commodity prices are apparently forecasting a sharp economic and earnings deceleration. But if the U.S. economy is “double-dipping”, it has yet to manifest itself in the data. Over the last several weeks, second quarter GDP was revised higher to 1.3% and third quarter GDP is now forecast in a 1.5% to 2% range. September auto sales exceeded expectations, reflecting more plentiful inventories, and same-store retail sales for the month were generally strong. International data may be more mixed, but despite the pessimism, it is worth remembering that Germany’s economy is still extremely strong and that emerging market balance sheets are a paradigm of virtue compared to the developed world.

Whether market reaction to the mood swing over the last quarter is a correct assessment of deteriorating fundamentals or an overreaction exacerbated by fast money is difficult to tell. But in this high anxiety environment, investors find themselves forced to scrutinize each new economic data point and company disclosure, like the mariner’s wife searching the horizon for signs of her husband’s ship, seeking to confirm her anxiety or rejoice at his return.

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Now What
Having helped inspire higher commodity prices and inflation through an aggressive monetary policy that infected much of the world, the Federal Reserve now finds its hands substantially tied. Consumer prices in the U.S. have accelerated to an almost 4% annual rate and even core inflation is now running higher than the 2% level that constitutes the Bank’s new concept of price stability, introduced a year ago. With economic growth too frail to absorb idle workers and additional doses of strong monetary policy precluded by its adverse consequences, the Fed has been relegated to fiddling around the edges and standing by as a lender of last resort.

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Twisting in the Wind
Unable to print much new money, but under pressure to address the economic growth leg of its dual mandate, the Fed has embarked on a strategy of purchasing long term Treasury bonds funded by the sale of short term Treasury notes that it already owns. This attempt to “twist” the yield curve may lower long term interest rates slightly, helping home buyers, but the impact may be small given already low interest rates. As has been seen in Europe, where the European Central Bank’s Quantitative Easing has been “sterilized”, the impact on liquidity seems limited.

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The Risk-Free Mirage
The roots of the U.S. and European financial crises have a common link in the uncritical acceptance of third party credit ratings. In the U.S., almost no one had ever lost any material money buying mortgages secured by residential real estate. The collateral almost always remained stable in price or rose in value over time, bailing out poor decisions and allowing mortgages bundled into securities to be rated AAA. When the collateral became inflated in price, the down payments shrank, and the underwriting standards deteriorated, few realized or cared to critically assess the risks.

In Europe, a similar phenomenon occurred. The illusion of a link by the Euro to the sound German balance sheet allowed countries such as Greece, whose credit history included being in default on its government debt for much of the 19th century and a third of the twentieth, to borrow deeply at low interest rates. European banks, required by Basel II to back sovereign debt holdings with little or no capital, loaded up on these apparently risk-free, capital-efficient securities. The combination created a sovereign debt bubble and conundrum for the Euro zone.

In the U.S., the housing crisis required the nationalization of the mortgage lenders, Fannie-Mae and Freddie-Mac, and a bailout of a variety of public financial institutions. In Europe, the resolution requires a bailout of individual countries, or, in the alternative, a bailout or nationalization of the banks that are glutted with sovereign debt. Given the difficulties of enforcing fiscal discipline across political borders and cultural divides, politicians are finally arriving at the conclusion that it will be easier to bail out the banks with additional capital than to meddle in other countries’ affairs. Under this alternative, a Greek default is likely soon.

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Outlook
We continue to believe that the root cause of sluggish economic growth is high leverage that needs to be resolved. In the U.S., that leverage can be seen in a still unsustainably low savings rate and high federal deficits, in Europe by unsustainably high government spending and sovereign debt levels. The solutions to both of these problems are not very pleasant, take time and require patience. Partisan political bickering, frequent financial crises and the magnification of modest economic swings by high systemic leverage only serve to increase uncertainty and delay the ultimate resolution and recovery. In Europe, a decision to bail out the banks, while restructuring peripheral country debt, would do much to defuse the current crisis, while the inevitable deterioration of political discourse in the U.S. will likely delay the address of the federal budget deficit until after the election.

The resolution of the low domestic savings rate will take time. Currently at 4.5%, it remains far below its post-World War II average of about 8%. Forecasting a return to this level requires no greater insight than a reversion to the mean, but, like all means, time must be spent above it as well as below. Should the environment become more stable and anxiety fade, a gradual rise can be absorbed with less pain, but should politics, crises and volatile markets interfere, the adjustment could be swifter, with harsher implications and unintended consequences.

Over the last several years, we have found that good companies that we believe to possess strong fundamentals have been knocked about by market anxiety with increasing frequency. Although it is sometimes difficult to tell the difference between market volatility and a change in fundamentals, we count on our discipline to keep our portfolios invested in positively surprising companies in the belief that the market will eventually recognize their strength. Over short periods the market can take profits to the detriment of our clients, but over time we believe that bottoms-up stock picking will generate superior results. As painful as the third quarter stock market declines have been, recent economic data suggest that the U.S. is not in recession, giving us confidence to add to individual stocks when opportunity presents.

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