Only the last point seemed to matter to investors as markets fell once again. Clearly investors are paying attention only to the negative news.  That same attitude is also apparent in stock earnings estimates as markets are already pricing in a lower level of earnings for next year.  The S&P 500 earnings for 2012 could go from the current $110 forecast to $85, a 20% drop that a mild recession might drive, without requiring stocks to fall further and still stay at historical valuations.  That’s a pretty good cushion of comfort!

Stocks are not the only financial assets pointing to a possible recession.  The credit markets are signaling that the U.S. economy is headed back into recession as does the action in the copper market over the past week.  High-yield bonds also appear to anticipate a marked deterioration in economic conditions and a corresponding surge in defaults, probably much worse than what actually lies ahead. Yield spreads—the extra return investors get in compensation for risk—have widened sharply.  The actual data, though weak, is not signaling the same recessionary conditions that are being priced into stocks and other financial assets.  A Chinese manufacturing index advanced for a second month in September, as a measure of new export orders rebounded to the highest level since May.  The Chinese Purchasing Managers’ Index (PMI) was at 51.2, compared with 50.9 in August.  A level above 50 indicates expansion.  September’s manufacturing reading, the highest in four months, suggests the world’s second-largest economy is weathering Premier Wen Jiabao’s campaign against inflation that has included higher interest rates, lending curbs and home- purchase limits.  The Services PMI in China bounced back to a robust level of 59.3 in September, more evidence that China appears to be successfully engineering the ‘soft economic landing’ they were looking to achieve.

Among the many adages that stock market followers repeatedly come back to is that “stock markets have predicted 11 of the last 5 recessions.”  The implication of this glib phrase is that the stock market has traditionally filled a role as an exceptional lead indicator of economic activity as it has fallen in the year preceding pretty much every recession over the last 80 years.  But it has also fallen on numerous occasions seeing a subsequent recession, thereby giving a false signal.  While the final outcome will not be known for some time, we believe that investors are panicking due to the demoralizing headline news and dearth of real economic or earnings data in the past few weeks and just selling because markets are falling and they’re worried rather than because we are actually heading into another global recession less than 2 ½ years after coming out of the prior recession.

The most recent push to the downside for stocks came after the release of US Federal Reserve Board comments from their meeting on Sept. 21st that said that there are “significant downside risks to the economic outlook, including strains in global financial markets”.  The ‘significant downside’ comment was new and panicked investors further, leading to a large scale liquidation of financial assets over the rest of the week, particularly the commodity-related assets that would be most at risk in a global recession.   The technical condition of the stock market is still to the downside and the momentum is exceptionally negative but the key U.S. stock market averages have not broken through the support levels seen at the August 8th lows, even though the Canadian market did close below those levels.  Our view is that the economic and corporate earnings data, though slower than earlier this year, are nowhere near the levels being priced into stocks and commodities currently.  While sovereign risks in Europe have definitely increased, there have yet to be any defaults and the majority of the financial institutions are still comfortably above the levels required in any stress-testing scenarios.  While stock and commodity markets have effectively ‘priced-in’ a moderate global recession, the economic data are nowhere near as dire.  Recent corporate earnings guidance, global growth indicators and commodity supply-demand balances all point to a slowdown in growth over the past two quarters but no recession.  Financial markets are either correctly anticipating a severe, near-term slowdown in growth or else they are in the process of creating another tremendous buying opportunity, similar to the early 2009 period.  Our view continues to be that it is the latter.

Sentiment is one area where the bears have taken clear control, both on the markets and the economy.  A CNBC viewer poll taken on Friday (Sept. 23rd) found 63% of respondents expecting an ‘economic depression’ beginning in the next year!  The relentless bad news on headlines and the constant replay of investment opinions from the most pessimistic prognosticators has succeeded in demoralizing investors and even impacting consumer and business sentiment surveys.  Our strategy in this environment of panic is to focus on the actual data and the investment metrics that we have used for the last 30 years to position the portfolios we manage for longer-term growth.  For us, this strongly suggests an overweight position in stocks relative to bonds and cash with a focus on those companies that benefit from global expansion that will be lead by the emerging economies, which now make up over 30% of the global economy.  Technology companies are positioned to benefit from global productivity growth and are at the lowest valuations ever seen for that sector.  Energy, industrial and basic materials companies are generating substantial cash flows and starting to use these cash positions to acquire and expand.

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