Debt, Earnings & The Euro

Stock markets have come under pressure recently as concerns over debt levels of governments around the world take center stage.  Policy makers are at a difficult juncture.  They must support global economic growth or risk losing much-needed tax revenue, while at the same time figure out how to cut spending to curb soaring budgets.  Arguments over this tradeoff are playing out in our own backyard as California attempts to address its $19 billion budget shortfall.

Cleary a cyclical business expansion is underway, which drove markets higher for most of 2009 and the start of 2010.  However, we have to consider how much influence government stimulus is having on the expansion.  With the Fed no longer purchasing mortgages and trillions already poured into the system, additional monetary and fiscal action by the U.S. government could ultimately unleash inflation.  Most of the bailout funds to date are held on the balance sheets of banks and the Fed; not in the hands of consumers.  Capital infusions to consumers and businesses, direct (think rebate checks) or indirect (think tax cuts and credits), would be a logical inflation trigger and one of the few policy actions left.  An increase in taxes to raise revenues could be a drag on spending, which may hold down inflation, but could slow growth and negate the projected revenue increase.

Corporate earnings and sales growth, while somewhat improved, could suffer as cost cutting options become more limited and the influence of stimulus and bailouts spending on sales growth are reduced.  U.S. companies have tightened their belts which shows up in high unemployment numbers.  It is difficult to say how much impact stimulus and bailout money has had on increased sales, but is sure to have played a role.  Taken in the context of valuations, using a Q1 2010 GAAP earnings estimate of $60.83 and a fair value P/E of 15, the S&P 500 should be trading at 912.  The S&P 500 does not have to trade down to a fair value P/E, but today's P/E of 18.65 base on a recent level of 1,135 may be a little rich given the many global economic challenges currently faced.

The big question is this: Where does future growth come from?  U.S. consumers have eliminated some debt, but a return to the purchasing patterns of the last couple of decades is unlikely especially since the home equity ATM is no longer open for business.  Can we expect consumers in emerging countries to fill the gap?  There are encouraging signs in consumer activity in emerging markets, but it is still too early to tell if consumers in Asia and other parts of the world will make up for reduced consumption by Americans.  From a GDP perspective, according to the IMF the BRIC countries (Brazil, Russia, India, China), combined 2009 GDP totaled approximately $8.9 billion, well shy of the U.S. at $14.2 billion.  U.S. consumption is estimated to represent approximately 70% of our GDP.

Regarding the European Union countries, they have serious issues in their common currency and run the risk of defections.  After years of some countries ignoring deficit and debt provisions, it may be too late to save the Euro.  Part of current market weakness is a vote of concern over the $1 trillion rescue package.  We can expect big announcements out of the ECB and member countries in the near future.

All this said, the market is behaving badly and the risk of a major correction (even market dislocations) has increased, in my opinion.