Late Friday, Standard & Poor’s (S&P) announced a downgrade of its US sovereign credit rating by one notch to AA+ (down from AAA). Coupled with recent soft economic data and uncertain global equity markets, this has made for disturbing headlines and heightened investor anxiety.

In our view, the panic selling over the last few days is an overreaction and not an accurate reflection of the health of Corporate America. During these volatile times, it is important to assess the situation with a clear head and focus on the facts.  

While we believe this is a good time for investors to reassess their appetite for risk, perhaps it’s not the best time to make hasty, drastic changes to your investment plan.

Instead, let’s take a step back to review what’s happened, and then we’ll explain what adjustments we’re making to our Banyan managed investment portfolios.

Risk Off … Again

Just over a week ago, the White House and Congress finally reached a compromise on debt-ceiling negotiations. Although a deal wasn’t struck until the eleventh hour, markets appeared to be relieved by the resolution, but that respite didn’t last long.

Downbeat data on the US economy, combined with lingering concerns about the debt crisis in Europe, sent stocks sliding. The S&P 500 dropped 7 percent last week, followed by another 6 percent loss on Monday, while bond prices have climbed steadily higher.¹

This is an extension of the “risk-off” pattern that has returned over the past few weeks. During a “risk-off” phase, investors move away from assets perceived as higher risk, like equities and even commodities (with the exception of gold), and rush into the perceived safety of US Treasuries and gold.

However, the magnitude and velocity of the stock market’s latest decline is surprising given that many of these problems are already well known. In our opinion, a combination of factors — none too sinister individually — is collectively undermining sentiment and confidence. Markets worldwide are built on confidence, which at times like this can be in short supply.

Watching for a Renewed Uptrend

Recently, the negative news on the economy has mostly outweighed the positives. Disappointments include:

Persistently soft jobs data and ongoing weakness in housing.

A downtrend in manufacturing production and overall business activity.

Downward revisions to gross domestic product (GDP) that shows the recovery has been weaker than expected.

Coupled with the domestic slowdown, lingering debt problems in Europe are another cause for concern. Not surprisingly, consumer confidence has taken a hit as a result.

In spite of the negatives, it’s important to point out we’re experiencing a slowdown in the rate of economic growth, not an outright contraction at this point. While there are plenty of reasons for investors to be concerned, more recent economic data has begun to improve including:

A rebound in last week’s employment report with 154,000 private sector jobs created in July.²

Retail sales have remained surprisingly resilient considering the downturn in consumer confidence.

Corporate sales and profit growth continue to surprise on the upside.³

In addition, lower oil prices are likely to provide some much needed relief to consumers and businesses.

The Citigroup Economic Surprise Index illustrates this point. The index fell sharply from March to June, but in recent weeks negative surprises have subsided, and the index has rebounded somewhat. Perhaps this represents the start of a renewed uptrend in the economy and indicates that the worst of the soft patch may have already passed.⁴

We recognize the potential for a double-dip recession is on the rise, and we’re on the lookout for any warning signs of further weakness. However, we believe the chances of recession are still a long shot at this point — with odds of less than 20 percent. Instead, we expect a pickup in economic growth later this year, although the rate of growth may be more subdued.

Our Stock Market Outlook

In terms of our stock market outlook, we are investing more cautiously, but remain optimistic over the long term.

In our view, and by historical standards, many high-quality companies are now undervalued based on solid long-term fundamentals. We also recognize that a slowing economy could reduce expectations about future earnings growth and, in turn, undermine valuations.

Keep in mind that the S&P 500 Index has already shed 15 percent from the highs recorded in early May — just three months ago — which means a slower growth scenario may have already been discounted in current share prices.⁵

Despite declines in share prices, overall corporate profits are rising, balance sheets are much stronger, and many companies are raising dividends, repurchasing shares and indicating confidence in their businesses.

At the same time, we are aware that markets can remain irrational and defy logic by declining further in the short term. In light of this, we continue to take steps to lower the risk profile in Banyan core equity portfolios where appropriate.

Remember, we began this process in May, when the S&P 500 Index was still near its highs. This doesn’t mean we are randomly selling into market weakness. It does mean that in certain circumstances we pared back our weightings in economically sensitive sectors where uncertainties are on the rise.

Longer term, we believe companies on our Banyan Buy List offer outstanding appreciation potential and we expect a solid rebound in these shares. At this time we believe it is prudent to remain cautious and be patient for the short-term uncertainty and market volatility to clear.

Meanwhile, we are selectively looking to add more defensive stocks to our equity accounts as volatile markets create long-term buying opportunities. Our preference is for high-quality, dividend-paying companies that can provide more stable returns in turbulent markets. For example, dividend-paying stocks in the S&P 500 were up 2.2 percent year-to-date through the end of July compared to a loss of 0.1 percent for non-dividend stocks.⁶

As we pointed out in last week’s Banyan Market Letter (Issue #28 • Aug. 3, 2011), while the US government piles up record deficits, Corporate America has boosted cash holdings for 10 straight quarters, to more than $960 billion — up 58 percent since the end of 2007. This quote from a recent Bloomberg news article accurately sums up our view: “Many corporations are in better shape than even the United States ... in a position to weather pretty much any sort of financial storm.”⁷

Our Fixed Income Outlook

For fixed income investors, the current “risk-off” environment has propelled bond portfolios higher. In fact, intermediate US Treasuries gained 0.5 percent last week and are up 4.2 percent year-to-date. Investment grade corporate bonds also jumped nearly 1 percent higher during last week’s turmoil, and are up 6.7 percent so far in 2011.⁸

In our Banyan custom fixed income portfolios and our mutual fund fixed income strategies, such as the Global Fixed Income strategy, we continue to focus on shortening our average maturities to a range of three to five years or less. Shorter maturity securities can help cushion fixed income accounts from sharp fluctuations in credit markets.

Although overall interest rates have declined sharply in recent weeks as bonds rallied, our goal is to maintain average yields of about 5 to 6 percent for our fixed income clients while being mindful of risk.

We anticipate the impact of S&P’s credit rating downgrade on fixed income markets to be much less than expected for several reasons:

The downgrade was widely expected and telegraphed ahead of time.

Two other rating agencies maintained their AAA credit ratings on US debt.

The rating change will have no impact on banks’ risk-adjusted capital ratios.

S&P also kept US short-term debt ratings at the top A-1+ level, which means investors should see no major disruption in short-term money market and bond funds.⁹

In other words, this “credit non-event” is nothing like the extreme stress experienced in 2008. In spite of historically low yields, many investors prefer fixed income holdings to help protect their portfolios in turbulent markets. And just yesterday, the Federal Reserve pledged to keep benchmark interest rates pegged at exceptionally low levels for the next two years!

Keep a Long-Term Focus in Times of Stress

Rest assured, we are always closely monitoring our clients’ portfolio investments — both equities and fixed income holdings. We constantly reexamine the fundamentals of each and every company we own in client accounts, including the cash flow, balance sheet strength and long-term growth potential.

As always, we will proactively reduce or eliminate any stocks when appropriate, replacing these with holdings that offer better long-term prospects. For the moment, prudent wealth management dictates that we are willing to sacrifice short-term opportunity cost to avoid realizing a loss of principal.

At the same time, we will take further steps when necessary to help mitigate downside risk in your portfolio. This may, when appropriate, include adding inverse mutual funds or ETFs that are designed to appreciate in value when markets decline.

For qualified clients, we also use defensive equity options strategies to help mitigate downside volatility from individual stocks or the overall market. Also, we will increase cash levels as appropriate in anticipation of promising buying opportunities to come.

The Banyan Partners investment team has many decades of professional experience managing money for clients. This includes extensive experience investing during turbulent periods in the past such as the inflationary markets from 1975-1981; the 1987 stock market crash; the bear market from 2000 to 2002; and the financial crisis in 2008.

We recognize that the current environment is complex with a confluence of factors impacting markets. Based on our experience, however, we feel this is a temporary correction, not a change in the market’s fundamental trend. For these reasons, we have learned it’s difficult to time the market in the short run because it’s never easy to sidestep short-term volatility without undermining your long-term investment goals.

Recall that last year the S&P 500 Index experienced a volatile 17 percent decline peak to trough, but went on to end the year with substantial gains. We have no way of knowing what the market will do in the near term, but as investors we must maintain a long-term focus especially during times of unusual market stress. What is clear is that we are closer to what should prove to be an attractive long-term buying opportunity.

Good investing,

Mike Burnick
Director of Client Communications
Banyan Partners, LLC

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The opinions expressed in this newsletter are subject to change without notice and do not represent a complete analysis of every material fact with respect to the economy, financial markets, and any industry or sector mentioned in this report.  Investors must make their own decisions based on their specific investment objectives, risk tolerance, and financial circumstances.  This report is solely for informational purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy.

The Citigroup Economic Surprise Index is defined as the weighted historical standard deviation of data surprises.  A positive reading suggests that economic releases have on balance beating consensus.  The index is calculated daily in a rolling three-mouth window.

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¹ Bloomberg market data, 8/9/11
² Bureau of Labor Statistics: Employment Situation Summary, 8/5/11
³ Bloomberg: Record Cash Showing S&P 500 Finances Beat US as America Loses AAA Rating, 8/8/11
⁴ Fidelity Investments Market Update, 8/8/11
⁵ Bloomberg market data, 8/9/11
⁶ First Trust Market Watch, 8/8/11
⁷ Bloomberg: Record Cash Showing S&P 500 Finances Beat US as America Loses AAA Rating, 8/8/11
⁸ First Trust Market Watch, 8/8/11
⁹ Bloomberg: S&P Affirms US Short-Term Rating May Prop Money Markets, 8/8/11