Investors are too focused on the negative data and headlines and are missing many positive actions that suggest that the economic situation will not get nearly as bad as most expect and that stock prices have already made an adjustment downward for these lowered expectations.  Some of the positives that came out in the past week that have effectively been ignored include:

  1. The recent announcement that United Technologies will pay over US$16.5 billion in cash to acquire Goodrich Corp at a price 47% above its prior day’s close.  While not immune from mistakes, it’s hard to see large corporations doing such deals if they were worried about deteriorating economic conditions.  Many such deals have occurred in a variety of industries over the past few months, including Google’s US$12 billion purchase of Motorola Mobility.
  2. China is successfully engineering a ‘soft landing’ on their economy as they unwind inflationary pressures (which are already on the decline) while slowing growth to a more moderate level.  While the negative focus has been on the ISM surveys bordering on the 50 level, the line between expansion and contraction, we heard very little about the most recent ‘flash business survey’ which rose to 59.3 in September from 55.4 in August, indicating a return to higher growth for the balance of 2011.
  3. The recent commentary and earnings guidance from global corporations that have always been great lead indicators of future financial and economic activity (i.e. UPS, Fedex, BHP, Dupont, Caterpillar, tech companies) remain positive, pointing to continued expansion in emerging economies, northern Europe and the US.
  4. Most of the very bearish economic readings came from ‘sentiment related’ indicators (i.e. data from surveys of individual or businesses as opposed to ‘harder’ data on items like retail sales or industrial production).  These sentiment indicators do tend to be somewhat more volatile since they are influenced by news events and public opinions, as opposed to just the basic data from other indicators.
  5. Stock valuations of cyclical companies is already reflecting dire economic conditions.  Cliffs Inc., a producer of iron ore, has fallen over 40% in the past two months to under $60, even though earnings are expected to hit over $13 per share this year and over $17 next year.  The stock is effectively reflecting iron ore prices of US$110 per tonne when the price of the commodity is firm at US$175 currently.  Auto stocks GM and Ford are trading at under 5 times current earnings despite the fact that auto production is still rising and earnings are expected to show strong growth this year and next.

There just seems to be a trend lately to focus only on the negative aspect on any piece of news.  Coal stocks fell sharply after both Walter Energy and Alpha Coal announced that they would not meet earnings guidance for the quarter.  The reason for the ‘miss’ was not a cancellation of orders or economic weakness though, but because they each had mine production problems that would limit how much they could produce on the quarter.  In theory, this restricted supply should lead to higher coal prices, not lower ones, so it seems fairly illogical that all coal stocks dropped so much on this news.  A similar story occurred in the oil patch where the IEA (International Energy Agency) dropped their global demand outlook for next year by 200k barrels per day (in a market of over 86 million barrels per day).  However, in the same release, they also reduced non-OPEC supply by an identical 200k barrels per day.  The net effect of identical drops in both supply and demand should be nil, in theory, but investors treated it as a reason for heavy selling in the oil stocks.

While the sentiment of investors is at rock bottom levels, the classic economic signs of recession just aren’t as apparent.  Pretty well every global recession since World War II has been preceded by an inverted yield curve and a year-over-decline in the leading indicators.  Right now, neither of those conditions are even close to taking shape.  Meanwhile, global stock valuations and sentiment indicators have fallen back to the 25-year low levels seen in early 2009 despite the fact that interest rates have fallen to levels not seen since the 1940s (which, in theory, should lend support to stock valuations).  The fact that the ratings agencies downgraded US debt in the summer and European banks in the past week has also increased investor fears.  But ratings agencies have typically been ‘lagging indicators’ of the actual changes in the market.  They wait until data is confirmed which is generally long after the stock markets have taken the same scenarios into their outlook.  Panic is creating tremendous buying opportunities in many strong global companies and our strategy is to continue to add to these names and increase equity exposure within the portfolio even though the short-term volatility of the markets will remain.

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