It's deja vu all over again.  How do we know?  Well, a glance back at The Big Picture column from July 26, 2010, tells us so.

In that note, we commented about a number of macro factors -- Europe's sovereign debt problems, China's efforts to slow its growth, and ongoing weakness in the U.S. labor market-- that precipitated a 17% slide in the S&P 500 between the high on April 26 and the low on July 1, 2010.

Today we find ourselves talking about... Europe's sovereign debt problems, China's efforts to slow its growth, and ongoing weakness in the U.S. labor market as catalysts for a 7% slide in the S&P 500 from its high of 1370.58 on May 2.  It would be remiss not to mention the supply chain disruptions from the earthquake in Japan, high oil/gas prices, the end of QE2, and the political standoff in Washington over raising the debt ceiling as added concerns.

The point is, if market participants want something to feel nervous about, they don't have to look far to find it. 

The concerns stack up like hotcakes on a plate at IHOP.  Fittingly, it feels right now as if the equity market is melting like butter on hotcakes.

It isn't really.  It's just that the market isn't showing the same buy-the-dip resolve it did earlier this year.  Hence, a 7% decline over a span of seven weeks feels like bear market misery following a period in which the S&P 500 gained 30% almost without interruption over a span of eight months.

Then and Now

We recognize today's cynics will attribute the equity market rally solely to the Fed put that was capitalized with the implementation of QE2 and, in turn, will posit that the impending end of QE2 (June 30) means the bull market run is over.

It doesn't have to be and it probably won't be, even if we see further selling in the near term as the many pockets of macro uncertainty get lined with worst-case scenarios.  On that note, it is worth repeating a few lines from the last installment to this page. 

When asked in an interview about our thoughts on how the second half of the year might play out for the equity market, I said it is our view that the summer months could see some irrational thinking that drives some emotional selling, which then leads to some common-sense investment opportunities.

And here we are.

Frankly, it might have been sufficient this week to repost The Big Picture note from July 26, 2010, and call it a day.  However, commentary provided then on the impending mid-term election and the impending expiration of the Bush-era tax cuts would create too much of a dated feel in reposting the entire note today. 

Instead, we have provided a synopsis of remarks made then to reinforce the point that today's concerns have a familiar ring to them.

(From July 26, 2010):

• Then:  There is a fine line that still needs to be walked when putting money to work in the stock market. That seems to be the primary message anyway from the Treasury market where the yield on the 2-year note hit a record-low 0.55% in the past week and the yield on the 10-year note dipped as low as 2.85%.
  
  Now:  The 2-year note hit a record low 0.31% last week while the yield on the 10-year note dipped below 2.90%.
  
  
• Then:  Right now market participants seem either scared, confused, disinterested, or all of the above. Our conclusion here rests on the understanding that trading volume across U.S. exchanges has been relatively weak and that new money continues to pour into bond and income funds, as the return of capital continues to take precedence over the pursuit of a return on capital.
  
  Now:  The Investment Company Institute estimates weekly net new cash flows into equity funds (and domestic equity funds specifically) have been negative every week dating back to May 4.  Net new cash flows into bond funds were estimated to be positive every week dating back to May 4.
  
  
• Then:  It is no surprise that the possibility of a melt up in the stock market is drawing scant attention.  Again, that fits with human nature, which is strongly predisposed to getting trapped in the echo chamber. That chamber is filling up with plenty of negative thoughts at the moment as economic data have been validating the slowdown argument.
  
  Now:  Incoming economic data have been validating the slowdown argument and that is making it very easy to subscribe to worst-case scenarios regarding macro developments.
  
  
• Then:  What does it say, though, that participants are not in any hurry to buy into the S&P 500, where the current forward four quarter earnings yield is 8.0%, yet appear enamored with buying a 10-year note yielding 2.90%?  That is a significant equity risk premium, which we said a few weeks ago is either a gift from the value gods or a bedeviling indication that earnings growth estimates are going to need to be marked down considerably.
  
  Now:  The forward four quarter earnings yield for the S&P 500 is 8.15%, the yield on the 10-year Treasury note is 2.90%, and the forward four quarter consensus earnings estimate has risen from $88.15 on July 26, 2010, to $103.63 today.
  
  
• Then:  Big, scary thoughts like a domino effect of sovereign debt defaults in Europe, or an asset bubble popping in China, or the U.S. falling back into recession, have killed the momentum of the recovery trade and have resuscitated the risk aversion trade.  It does not matter right now that these may be overblown concerns. The perception that they could easily present a systemic risk is enough alone to keep investors at bay.
  
  Now: Same thought is prevailing today.
  
  
• Then:  This fiscal imbroglio in Europe precipitated a massive flight-to-safety in the U.S. Treasury market. The latter move notwithstanding, there is an undercurrent of concern that the U.S. could be on a path toward a day of reckoning with bond vigilantes, too, if it does not get its deficit (now 9.3% of nominal GDP) under control soon.
  
  Now:  The yield on the 10-year Treasury note has dropped roughly 70 basis points since mid-April, fueled by concerns about a potential debt default in Greece.  Notwithstanding the drop in Treasury yields, the day of reckoning argument for the U.S. remains alive and well as politicians in Washington continue to bicker about raising the debt ceiling and have yet to come up with a solution for getting long-term deficit issues under control.
  
  
• Then:  The Dodd-Frank Bill has been signed into law, yet the big banks are calling attention to the potential for unintended consequences (i.e., bad things) resulting from the bill. While the big banks were reluctant to quantify how the new regulations would impact their income statement, a recurring theme in the earnings reports was that regulatory uncertainty is making it difficult for them to do business.
  
  Now: Banks continue to say the same today.  JPMorgan Chase CEO, Jamie Dimon, even challenged Federal Reserve Chairman Bernanke publicly with a loaded question of asking whether regulators might have gone too far with their regulations and, consequently, are responsible for slowing economic growth.
  
  
• Then:  The S&P 500 currently trades at 12.4x forward four quarter earnings, which is below the average forward four quarter P/E ratio of 14.3x over the previous 52 weeks. Applying the average forward four quarter earnings multiple to the current consensus earnings estimate of $88.15 computes to a 1260 price level for the S&P 500.
  
  Now:  The S&P 500 reached a peak of 1370.58 on May 2 before falling back to a low of 1261.90 on June 15.  Currently, the S&P 500 trades at 12.3x forward four quarter earnings, which is below the average four quarter P/E ratio of 12.9x over the previous 52 weeks.  Applying the average four quarter earnings multiple to the current consensus earnings estimate of $103.63 computes to a 1336 price level for the S&P 500.
  
  
• Then:  We respect the idea, however, that the market often operates in a way that catches the majority of participants by surprise. With that in mind, it behooves us to contemplate what the biggest surprise would be right now.  Our sense is that the biggest concern out there is that the U.S. stock market is poised to suffer another large decline. That is why the participation factor has been low; that is why the so-called smart money is not buying stocks eagerly despite an 8.0% earnings yield on the S&P 500; and that is why banks are sitting on their excess reserves and why companies are hoarding cash.  It seems to us then that the biggest surprise at this juncture would be a melt up in the stock market, not a meltdown.
  
  Now: Same thought is germane today.

Full Circle

This is a tough environment to sell a bullish market outlook.  The stack of concerns is building.  Then again, so is the stack of potential catalysts to get the market moving higher again.  One doesn't have to look far to see those catalysts either, because they are grounded in the very concerns that have brought us to this point.

Greece... the end of QE2... high oil/gas prices... Japan... a potential hard landing in China... a slowdown in hiring in the U.S... an inability to reach an agreement on raising the debt ceiling... no solution in the U.S. for tackling the long-term deficit issue -- these are the things that are dominating the information highway and which are forcing investors to the side of the road.

As it so happens, these are the same concerns the market had a year ago, only then gas prices weren't quite the issue they are today and we were talking about the end of QE1.

The main difference today is that the equity market, in spite of all of the concerns then, is 15% higher than it was when we published the July 26, 2010, column (it was 24% higher at its high on May2).

The implementation of QE2 influenced that run, but it is too narrow-minded to think it was the only reason for the run.  S&P 500 operating earnings were up 40% in 2010 -- and that was with the quiet period for quantitative easing between March 31, 2010, and November 3, 2010.

Much is often made of the fact that the S&P 500 dropped 18% after the end of QE1 in an attempt to show cause and effect.  That perspective, however, typically leaves out the point that the market rallied nearly 4.0% between March 31 and April 26 and that the Greek debt crisis blowing up on April 27, when Standard & Poor's cut Greece's credit rating to junk status, was a coincidental shock to the market.

With the scent of fresh systemic risk in the air then, fears of a double-dip recession in the U.S., and everyone purporting to see black swans in the water, the Fed was compelled to institute QE2 to restore confidence in the recovery prospects for the U.S. economy and the equity market. 

Well, we have come full circle. 

The Fed will end QE2 on June 30 and, sure enough, Greece is at another boiling point.  That doesn't mean QE3 is around the corner, but all options are on the table for the Fed, which has taken every opportunity to highlight that it is obligated to satisfy a dual mandate that calls for maximum employment and price stability.

Possibilities

QE3 is a low probability at this point and so there are understandable concerns that the economy and the equity market cannot stand on their own -- concerns that have only been made worse by economic data that, coincidentally, got noticeably soft following the Japan earthquake, the spike in oil/gas prices, the talk of Congress perhaps not raising the debt ceiling, and the renewed angst about Greece and the fiscal problems in Europe.

The implication is that these nettlesome factors can also be addressed in short order in a manner that restores confidence to the equity market.  The solutions need not be perfect -- and they probably won't be -- but they just need to be good enough to extinguish worst-case scenarios.

To wit:

• Greece is a mess and everyone knows it.  There is talk that a default by Greece could ignite another crisis that resembles the one that followed the Lehman Bros. bankruptcy.  No one knows with certainty if that would be the case, but we suspect policymakers don't want to find out and that a bailout solution will be forthcoming.  Yes, it will be kicking the can down the road, but at this juncture, that will ultimately be preferred by market participants than having the legs kicked out from under the capital markets by a debt default that could ignite a domino effect.

  Recent history shows European leaders are experts at 11th hour solutions. It's just pride and prejudice that always forces things to the brink and creates a lot of fear and loathing in the capital markets leading up to that point, as we witnessed last year.
  
  

• We have already seen a pullback in average gas prices from $4.01 a gallon on May 2 to $3.77 today.  That important point has gone unappreciated because it is being couched as a sign of the economic slowdown, yet to the extent that gas price relief creates more disposable income that consumers previously didn't think they would have, the greater the potential exists that spending data brings positive surprises in coming months that spill over to other parts of the economy.
  
  
• Japan is still recovering from the March earthquake and tsunami, but better economic data should be forthcoming as the shock of the natural disaster wears off and manufacturers regain the ability to ramp up production that restores broken supply chains.
  
  
• China has a difficult task in managing a soft landing, but it has shown policy resolve to arrest inflation pressures with six increases this year in the required reserve ratio for banks and four interest rate hikes since last October.  With real interest rates still negative, though, China has more work to do to cool its economy in a measured way, but it is on the right path.  Evidence consumer price inflation is leveling off on a year-over-year basis in coming months and that retail sales and industrial production are decelerating slowly would bolster soft landing expectations.
  
  
• While no solutions have been reached, it appears as if the Republican majority in the House is resolute in tying an agreement to raise the debt ceiling to the simultaneous imposition of deficit reduction measures.  Discussions on the latter have centered around numbers of consequence, meaning they are talking deficit reductions that reach into the trillions.
  
  With all of the global tumult seen before we have even reached the summer solstice, there is a high probability that Congress provides dual relief for the market in raising the debt ceiling and agreeing to measures that cut the long-term deficit.  Ideally, all of that will occur well before August 2, though it is probably worth noting that this is apt to be a case where the solution is far from a perfect solution (or a final one).
  
  
• QE2 ends on June 30.  Conventional wisdom suggests the economy cannot stand on its own without the Fed's continued support since interest rates are sure to jump after the predominant buyer of Treasuries since November moves to the sidelines.  Fed policy won't be getting tighter, though, since it is the Fed's intention to hold its balance sheet constant. 

  While we could see some upward marks in Treasury yields after QE2 officially ends (perhaps up to 3.50% on the 10-year if safe-haven premiums are also reduced), we expect buying interest in the Treasury market to remain sufficient so that a move in the benchmark rate from, say, 3.50% to 4.00% won't occur in a straight line.  More importantly, though, consumer and investor confidence would get a real boost if incoming data showed renewed growth momentum in a post-QE world.

A Truly Long-Term View

Confidence in the outlook is key right now and confidence is lacking.  Yet, if the concerns that have gotten us to this point can be checked off in the coming weeks and months -- and there are real possibilities that they can be -- then a repeat of last year's relief rally could be seen.

Regardless, our investment viewpoint remains unchanged. 

The long-term underperformance of the equity market during May-October relative to November-April is well documented.  It would not be surprising to see this year trend similar to last year, when the S&P 500 was very choppy through August with a prevailing negative bias.

The equity market is following the seasonal pattern so far this year and it has had a lot of headline help in doing so. 

However, our investment horizon is much wider than a 3-6 month horizon.  It spans much like the one viewed by Laurence Fink, CEO of Blackrock, which has roughly $3.7 trillion under management, and who recently said he isn't focusing on quarterly moves but on a five- to ten-year horizon.

Our research indicates that there is still good, relative long-term value in the equity market at the current price level. That is true certainly vis-a-vis Treasuries based on an equity risk premium that now stands at 525 basis points versus a 20-year average of 123 basis points.

Interim weakness, therefore, should be thought of as a long-tern investment opportunity predicated on relative value and supported by solid, albeit slowing, earnings growth, extremely low interest rates, strong cash flow and healthy balance sheets. 

On that final note, dividend-paying, U.S. multinationals with solid financial positions and increasing exposure to emerging and developing markets continue to be an attractive investment option as the market chews, and sometimes chokes, on its hotcakes.

--Patrick J. O'Hare, Briefing.com

Patrick J. O'Hare is the Chief Market Analyst for Briefing Research, Briefing.com's institutional research service. To request a free trial please email researchsales@briefing.com.