The Catalyst of Cooperation

Investors have a lot on their minds this fall. Between the impending fiscal cliff, European and Chinese woes and an election here at home, there’s a lot of unanswered questions holding investors back. But with worry comes opportunity. The American markets are trading at historically low price to earnings ratios. Many companies have large stockpiles of cash just waiting to be put to work. If we could only put these worries behind us, I think the economy has a chance to move ahead from the slow growth pace we are experiencing.

First we have to remove our worries. Fortunately I think the tides are turning. It’s all quiet on the European front with plans in place to offer support to countries struggling under their burden of debt. They are also working toward a closer banking union. We also tend to forget the obvious in China. While their growth rate appears to be slowing, it is still well above the activity level found here in the US.

Here in the U.S., the election in November and “fiscal cliff” in December are creating anxiety. The result of a combination of expiring Bush-era tax cuts on December 31^st and the already approved major reductions in spending, the “fiscal cliff” has the potential to profoundly affect all classes in the U.S. Most economists believe unless a compromise is reached in these areas, another US recession is likely to occur.

Last week, The Federal Reserve (Fed) announced plans for a 3^rd round of quantitative easing (QE3). Their plan is to buy $40 billion per month of mortgage-backed securities (MBS) bonds in an attempt to keep the already low interest rates at these low levels for an extended period of time. Their hope is that our fragile economy will have more time to gain footing and economic activity will increase. The housing market is of particular concern. There are signs of life and the Fed wants it to continue. They’re also targeting the labor market and, for the first time, are tying this program to growth in that area. * In their statement released last week, they said they would continue to purchase the mortgage-backed securities until “the outlook for the labor market improves substantially”. They said they would look at a range of indicators, not just the unemployment rate.¹

A fair question might be: what could be the catalyst to move the stock market ahead with so many headwinds? We see two things that can improve the situation:

• Because of so many concerns, the stock market in general is trading at a historic low range compared to what companies are earning in profit (price to earnings or P/E). If the economic or political outlook improved, we could see stocks move up to more of a historic level. Today’s P/E level is 13 times earnings – the historic level is approximately 15 times earnings. ²
• The fiscal cliff becomes the top priority after the election and through the end of the year. If progress is made and our politicians are able to find compromise on the issues – maybe a combination of spending cuts and some tax increase – this could reduce the anxiety felt by investors and a higher market could result, even with little growth in earnings.

The approval ratings of Congress and the President have rarely been seen at today’s low levels. By comparison, the last time America was this polarized was the Civil War. ³ The American people want the two parties to work together for the common good and a change in their sentiment could be a powerful thing.

Historically the United States has faced many challenges through the years. But it is evident that investors with patience, perspective and time come out ahead. Let’s all encourage our representatives to see what’s best for our country, not just their own agendas.