Time of greatest fear offers opportunity

Is it time for investors to follow Warren Buffett's dictim: "Be fearful when others are greedy and greedy when others are fearful"?

Story highlights

  • In 45 furious minutes this week, Wall Street was spared a mauling by the bears
  • Late on Tuesday the S&P 500 was submerged more than 20% off its April high
  • But economic data out this week suggests a feared double dip might not come
  • Buffett: "Be fearful when others are greedy and greedy when others are fearful"
In 45 furious minutes this week, Wall Street was spared a mauling by the bears.
Late on Tuesday the S&P 500 was submerged below the 1,100 level, more than 20 per cent off its April high and closing in on official bear market territory. Then a Financial Times report that European Union finance ministers were looking at a co-ordinated recapitalisation of the continent's banks triggered a 4.1 per cent rebound in stocks.
Whether investors avoid further losses this year depends on more than just what happens to Europe's banks, however.
Just as important, perhaps more so, is the question of whether the US will avoid slipping into another recession. While overshadowed by the headlines of the eurozone drama, economic data out this week raised hopes that the feared double dip might not be imminent.
First, on Monday, the Institute for Supply Management revealed that manufacturing was still expanding in the US even as it slowed elsewhere.
Then, figures released on Thursday showed that new claims for unemployment assistance had held steady at about 400,000 per week. As Jim Paulsen of Wells Capital Management notes, if the US was on the brink of recession, claims should be ballooning, not hovering. A steady claims rate is relatively good news: share prices tend to fall when jobless claims rise.
Finally, the most important release of the week was stronger than expected. The US added 103,000 jobs last month, the Bureau of Labor Statistics reported on Friday. The agency also revised an earlier reading of zero change in August to a 57,000 jobs increase.
Collectively, these data are a reminder that the fundamentals of the US economy are in better shape than many think. As such, any further action by central banks and European leaders to address the sovereign debt crisis there bolsters the case for equities.
Since the summer, US stock markets have been haunted by the prospect of a European bank collapse or the break-up of the euro. These scenarios have loomed over US banks, and the cost of buying insurance against a default on their bonds, via credit default swaps, has soared. Analysts have scrambled to calculate US banks' exposure to the European crisis.
Financials have fallen the most of any S&P sector in response to contagion fears, followed closely by materials and industrials, reflecting concerns about the strength of global demand.
The yield on 10-year Treasury bonds has fallen to below 2 per cent, pointing to a protracted Japan-style slump. Leading indices from the Economic Cycle Research Institute, a forecaster, shout recession.
But it is important for investors to recognise that the more probable outcome in Europe is likely to fall short of catastrophe. A technical recession, possibly, which would lead to a slowdown in US trade with Europe, but not a 2008-style crisis. The US economy should continue growing, and with it corporate earnings.
For all the gloom in financial markets, S&P 500 earnings per share this year are expected to hit a record $99.19, according to S&P Capital IQ. Much of those earnings are expected to come from consumer discretionary companies such as Amazon, Bed Bath & Beyond and Target. Consumer discretionary stocks have been outperforming.
"You should never underestimate US consumers," says Richard Jaffe, a retail analyst at Stifel Nicolaus. "They have been paying down debt and are in a position to go out and spend on their credit cards."
Another factor buoying US households is falling oil prices. Crude has declined more than $20 a barrel from its April peak, reducing inflationary pressure and leaving shoppers with more money to spend.
Over coming weeks, further data will clarify the uncertainty over US growth, while investors will scrutinise third-quarter earnings and guidance from companies. Any upside surprise will reward value investors who bought at a time of greatest fear.
Stock market sentiment is now almost as bad as it was in early 2009. But with the publication of US bank stress tests, that was also the point at which the market began a two-year bull run. It is worth recalling Warren Buffett's dictum: be fearful when others are greedy and greedy when others are fearful.