What do you get when you add blowout corporate earnings, record cash flow, low interest rates, improving trends in employment, and low inflation?  Normally the result would be a very strong stock market.  Yet, this past month has been anything but, including an eerie 1,000 point intraday drop on May 6th.  And we all know what has derailed an otherwise positive economic recovery story, that being sovereign debt woes particularly involving Greece and the European Union.  While the global business and political community tries to figure out a solution to the EU debt crisis, there is an important lesson for investors. 

Stock prices are impacted, to some degree, by all known information as well as the predictions, hopes, and fears about future events.  If this isn’t complicated enough, it can be even more challenging to determine which factors will impact stocks prices and which factors might be largely ignored.  Moreover, economic and fundamental analysis ultimately drives valuation in the long run, but emotions can overwhelm all logic in the short run.  And the screaming heads, too many of us listen to, escalate these emotional moments, making investors think that for each day’s development or crisis, or fear thereof, there has to be a reaction. 

But it gets worse…  The last decade has been one of the most difficult periods for the stock market on record, with the dual pain from the tech bubble bursting in 2000-2002 and the real estate meltdown in 2007-2008.  Not surprisingly, investor’s nerves are frazzled.  It seems we are in a mindset where any economic issue or geopolitical event must somehow validate our collective worst fears.  Gone, it seems, is a sense of optimism and resiliency that dominated our national psyche since its origin.  How long will we be stuck in this age of pessimism? 

For the record, the market has had 18 corrections of at least 10% over the past 75 years, with the most recent one occurring this past month.  The average return for the subsequent 1-6 months following these corrections was approximately 17%.  A reasonable argument for hanging in there, in my view. 

Does this apply to the present situation?...   Are the problems related to debt levels in Greece more important to driving stocks prices in the U.S. than all the positive economic factors mentioned above?  At least over the last few weeks the answer has been yes.  But how about longer term?  According to an article in the Wall Street Journal by University of Chicago professor John H. Cochrane, “Greek Myths and the Euro Tragedy,” a debt default by Greece would not pose systematic risks to the financial system.  According to Professor Cochrane, Greece does not have the complex swap contracts, derivatives, or counterparties that would be negatively impacted in a domino sort of way.  Yet debt remains the central issue, or more accurately, the primary obstacle to sustainable global economic growth and ultimately higher stock prices. 

I’ve written previously about a three-legged stool in this Great Deleveraging Cycle, involving individual families, corporations and governments.  To recap, families have and continue to rebuild their balance sheets.  Meanwhile, balance sheets at most large multi-national corporations have never been stronger, with cash levels at or near all-time highs. 

Governments will be the last to get their fiscal house in order.  Perhaps the process has started in the EU.  I am sure it will be painful and unpredictable.   I also have no idea how long it will take, but any meaningful progress will likely be a positive catalyst for stock prices, as it proved to be following the banking crisis in the U.S.  Moreover, investors holding back until the global debt problem has been completely resolved will miss most of the rally.  

So what are we doing during this recent turmoil?...  We are searching for opportunities to add to our core holdings and for situations where we can upgrade quality.  The highest quality stocks are rarely, if ever cheap, but sometimes they go on sale.  Disciplined analysis can uncover these temporary bargains.

The bottom line is that the world is coming to grips with a generation of living beyond our collective means.  The Great Deleveraging Cycle is upon us, and this process is going to take time and is inherently unpredictable, but the end result will be overwhelmingly positive. 

By continuing to create jobs, and by leading our government toward a level of fiscal responsibility to match the progress made by families and corporations, our national pessimism can be defeated.   We can regain our faith in ourselves and our country and we must.  How?  By living a life of integrity and by caring for and about others.  Small stuff really, but huge in a collective sense. 

Michael Kayes, CFA