“THE STOCK MARKET IS BUT A MIRROR WHICH …..PROVIDES AN IMAGE OF THE UNDERLYING OR FUNDAMENTAL ECONOMIC SITUATION. CAUSE AND EFFECT RUN FROM THE ECONOMY TO THE STOCK MARKET, NEVER THE REVERSE. IN 1929 THE ECONOMY WAS HEADED FOR TROUBLE. EVENTUALLY THAT TROUBLE WAS VIOLENTLY REFLECTED IN WALL STREET.”

– JOHN KENNETH GALBRAITH

The Fed’s decision to implement additional phases of quantitative easing (QE) has simply become a short-term sugar high for the stock market. Each subsequent announcement has generated a less resilient high than the previous announcement. In fact, the bump-up resulting from QE3 evaporated in less than two weeks. Unfortunately, we have become accustomed to the Federal Reserve smoothing out economic bumps since Greenspan came into office. Prior to Greenspan’s tenure, the economy (and the stock market) would, on average, experience a downturn every 4 years. As the quote from Mr. Galbraith so eloquently states, if the economy slows down, so will earnings which, in turn, will depress stock prices.

When it comes to earnings, where are we today? As recently as the 3rd quarter of 2011, corporate earnings were at an all-time high as a percentage of GDP. Please note, as indicated in the following chart, the prior two periods when corporate profits peaked were in 2000 and 2007. Shortly thereafter, we encountered two dramatic drops in equity prices.

We are now beginning to see earnings slow down.

In the past two weeks, some major bell weather companies (FedEx, Caterpillar and Maersk) that are tied to the economy have all cut future earnings projections. CEO economic expectations are also at their lowest level since 2009. Companies are not hiring and are reducing capital expenditures. These items will have a ripple effect on earnings and economic growth.

We are in a global economy and what happens overseas does affect our economy. A good barometer that measures the strength of an economy is the Purchasing Managers Index (PMI). This is a survey of purchasing managers based on five major indicators: inventory levels, new orders, production, supplier deliveries and the employment environment. A reading of over 50 indicates expansion while a reading of below 50 indicates contraction (i.e., recession). As you can see in the chart below, Europe, China, the UK and now the US’ (with a most recent reading of 49.6) PMI indexes are now below 50. This indicates a contracting economy, not an expanding one. A few other key issues to note about the chart:

1. All Country PMI’s trend in the same direction.
2. The current trend peaked at the end of last year and global economies have slowed dramatically since then.
3. The last time we started slowing down was at the beginning of 2008 (4 years ago – historical time span for recessions) and before the stock market’s correction.

If earnings are deteriorating at a time when corporate profits are at their highest historical level ever, what is the risk of a significant equity market decline? In our opinion, the risk is elevated at this time. There are other factors that also contribute to this increased risk at this time:

1. There are virtually no fiscal growth strategies around the world. Either governments are raising taxes (Italy, Greece and France) or reducing spending (Spain and Greece). Both of these strategies reduce growth.
2. Israel/Iran conflict. It is not a question of if there will be an armed conflict, but when. The only way to avoid an armed conflict is for Iran to stop its nuclear ambitions.
3. Europe’s problems are not over. The next step is voting for independence – Catalonia in Spain and Bavaria in Germany. Human nature of self-determination is coming to the forefront against elitist bureaucrats.
4. China is slowing down significantly. Some economists are predicting that China is where Japan was back in 1988 and expect annual growth to fall to 3% or less in the years ahead
5. Middle East uprising. There is a major battle occurring between the Sunnis (Saudi Arabia) and the Shiites (Iran). Saudi Arabia is backing the Sunni rebels in Syria while Iran is backing Assad and the other Shiites in Syria. Why is this important? Most of Saudi Arabia’s oil fields are in territories populated by Shiites. If this conflict spreads to Saudi Arabia, there will be a major disruption to oil markets.
6. If there is a major conflict somewhere around the world, the Federal Reserve has little room to pump the economy monetarily like it did after 9/11 with major interest rate cuts. They are running out of bullets.

While the stock market has been relatively resilient in the recent past, we believe the risk of a downturn is considerable. Our clients’ portfolios reflect this concern as we have sizeable positions in both cash and alternative investments. We see this as good risk management and will likely maintain this stance until after the November elections. At that point we hope to have a little more clarity in the global economic picture.

New team member

We are happy to announce the addition of Andrew Molnar to our research team. Andrew graduated in May, 2012 from The University of Dayton with a double major in Finance and Entrepreneurship. Andrew is from the Cincinnati area where he grew up in Blue Ash and attended Sycamore High School. Andrew has a strong passion for the investment business and a thirst for knowledge in global markets, economies and politics. In his free time, Andrew enjoys golf, basketball, reading, music and spending time with family and friends.