September certainly lived up to its bad reputation as one of the worst months on average for equity returns, and August wasn’t any better as the third quarter of 2011 ended on a low note.  

The S&P 500 Index suffered its worst quarterly decline since 2008, falling 14 percent during the period, while many international markets in both Europe and Asia fell even further.¹ Unfortunately, as the fourth quarter begins, stress levels in financial markets show few signs of easing.

Usual Suspects: Greece, Growth, & Gridlock

As we see it, the increased downside volatility is due to intensified concerns over the usual suspects that have had markets in turmoil for months: The ongoing European Union (EU) debt crisis and uncertainty over a slowing US and global economy not to mention the lack of confidence stemming from political gridlock in Washington.

While we remain hopeful that EU finance ministers will put their squabbling aside and come up with credible solutions to the debt crisis at this week’s monetary policy meeting, they haven’t exactly inspired much confidence so far. We addressed the ongoing EU comedy of errors in a recent article (Issue 34 • Sept. 14, 2011).

While the progress being made toward expanding the European Financial Stability Fund is promising, more work is required, and soon. What’s likely needed to calm markets is a TARP-like program from EU governments in coordination with the ECB, to shore up troubled European banks.

At this point, we believe any resolution, even if it involves a debt restructuring or partial default for Greece, would be preferable to the exhaustive uncertainty gripping global markets right now.

Meanwhile, in the US, attention will soon turn toward third-quarter profit results for S&P 500 companies. Earnings reports are in sharper focus as economic growth prospects have been downgraded.

The results we see from corporate America — especially their own forward-looking guidance on business conditions — could go a long way toward determining the direction of financial markets over ensuing weeks.

Recession Scenario Already Priced Into Stocks

On the bright side, the US economy appears to be in better shape relative to Europe’s woes and corporate America is better off than recent stock prices would suggest. Corporations are quite a bit healthier today, with stronger balance sheets and higher cash levels than during the credit crisis in 2008. In our view, this makes them better able to weather a storm this time around. Meanwhile, US consumers continue to spend, although sentiment remains weak.

Just a few weeks ago, the National Association for Business Economics (NABE) sharply revised US growth estimates downward for the rest of this year and for 2012. Economists surveyed by NABE now expect our economy to expand just 1.7 percent in 2011, down from an earlier forecast of 2.8 percent and actual 2010 GDP growth of 3.1 percent. But in 2012, they expect growth to rebound to 2.3 percent.²

Of course the stock market has downgraded growth forecasts already, as witnessed by the decline in share prices in August and September. But has the magnitude of this correction been an overreaction?

Stock prices seem to have discounted not only a sluggish growth scenario, but a probable recession. At Banyan, we feel the jury is still out, but sluggish growth has no doubt raised the risk of recession.

Still, current stock market values are already below what investors would normally expect during a typical recession.

The S&P 500 is currently valued at just 10.2 times expected earnings this year. That’s fully 25 percent below the average level experienced during the last nine recessions over the past 50-plus years. To put it simply, stocks are already priced as if recession were a done deal.³

Critical Earnings Season About to Get Started

In below-trend growth periods, volatility typically intensifies, and this time it’s no different. To top it off, we believe the political dysfunction in Washington along with the twin specters of the European crisis and the US debt downgrade have contributed to a severe lack of confidence, adding even more downward pressure to markets.

However, in our opinion, much of this news is also already priced into share prices at these levels. That means a lot will be riding on the third-quarter earnings season about to get underway.

Fortunately, the bar has been set extremely low for earnings results this quarter, making it easier for most companies to hurdle over expectations, in our view.

Earnings estimates, like GDP forecasts, have been pared back in recent weeks. Consensus estimates now call for third-quarter growth of only 2 percent over the same period a year ago.

Over the past 10 consecutive quarters, however, actual results have consistently beaten estimates — often by a wide margin — leading to positive profit surprises.

Driven by positive surprises and upbeat corporate guidance, stock prices have often rallied in the immediate aftermath of earnings season, with the S&P 500 gaining 6 percent on average.⁴

Historically, about two-thirds of S&P 500 companies have beaten their estimates and most companies have not guided profit forecasts lower this quarter, with overall estimates down just 2.6 percent over the past three months.⁵

With the third-quarter earnings season about to get underway, we’ll be closely tracking the results and focusing on what management has to say about corporate prospects in the months ahead. 

The bar is set unusually low right now and there’s no indication that actual earnings won’t beat estimates once again this quarter. If so, pleasant surprises (for a change) could provide an upside catalyst for the market, which is certainly in need of a relief rally, but disappointing results could reinforce negative sentiment. We should know soon enough.

In the meantime, in our Banyan Core Equity accounts we’ve taken the following steps that you may want to consider for your own portfolio:

1. We are holding extra cash where appropriate to help provide a cushion against volatile markets, while keeping some dry powder for excellent buying opportunities that are on our radar. We intend to be patient with new purchases until markets provide more clarity.

2. We’ve made every effort to lower the volatility of our equity portfolios by focusing on high quality companies. Our emphasis is mainly large-cap stocks with stable, predictable businesses and a preference for dividend yield. This approach is paying “dividends” in a volatile market as S&P 500 stocks with an A quality ranking outperformed C ranked stocks by 13.4 percent during the third quarter.⁶

Bottom line: We see current stock prices are already discounting a recession. Although we can’t rule out a further decline given the high degree of uncertainty, if we do manage to avoid an outright contraction and earnings results come through this quarter, it should provide a positive catalyst for share prices to move higher. Stay tuned.

Good investing,

Mike Burnick
Director of Client Communications
Banyan Partners, LLC

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¹ Bloomberg: S&P 500 Valuations Below Recessions Since ’57, 10/3/11
² NABE Outlook, 9/12/11
³ Bloomberg: S&P 500 Valuations Below Recessions Since ’57, 10/3/11
⁴ Bloomberg market data, 10/4/11
⁵ Deutsche Bank: US Equity Strategy, 9/28/11
⁶ Ibid.
⁷ Credit Suisse Equity Research, 10/4/11