After reaching its highest levels since the collapse of Lehman Brothers in the fall of 2008 on April 23, the stock market began its first major correction since bottoming in March of 2009. The stock market, as represented by the S&P 500, declined 11.8% from 1169 to 1031. Treasury bonds rallied, meanwhile, with the yield on the benchmark ten-year note declining to 2.95% from 3.83%. Also in the face of uncertainty, gold rallied 11.5% from 1115 to 1243. The initial catalyst was the fear of a financial meltdown in Europe due to the sovereign debt of nations such as Greece, Portugal, and Spain. After the European sovereign debt situation was at least temporarily stabilized by a trillion dollar rescue package put together by the European Union, the European Central Bank, and the International Monetary Fund, the anxiety of the markets morphed into concern about the sustainability of the American economic recovery. Further souring sentiment has been the fecklessness of both industry and government in dealing with the disaster in the Gulf of Mexico. Overall, the sentiment has been almost exclusively negative for the past two months.
Europe is likely to muddle through its debt woes. Although we cannot dismiss the possibility of the American economy sliding back into recession, we believe America will grind its way forward. While the unemployment rate remains at multi-decade highs, state and local governments struggle to balance budgets, and the residential real estate market flounders in oversupply, American banks are well capitalized, corporate cash is at record levels, and most American businesses are solidly profitable after massively increasing productivity through cost cutting during the recession. The fact that there is little fat left to cut is a good thing, as it means fewer potential job losses going forward. The outlook is by no means rosy, but we do not believe that these are the makings of another leg down for the American economy.
More troubling is the longer-term diagnosis. More needs to be done to accelerate growth. The anemic growth we are witnessing is setting us up for potentially severe economic and financial consequences further down the line. As is well publicized, the American Federal debt is accumulating rapidly, more rapidly than the current growth of the economy. If this trend continues, there will come a point someday where the ability of the American economy to support the national debt will be called into question. If this point is reached, the only solutions are severe and debilitating tax increases and spending cuts, money printing, or outright default.
We feel that the most politically expedient solution would be money printing. The implications would be higher inflation, much higher interest rates, little to no real economic growth and a perpetuation of high levels of unemployment. As the saying goes, we do not want to go there. The best way to avoid that fate would be to redouble our efforts to spur economic growth so that the economy will have the wherewithal in the future to finance its debts. Unfortunately, the political process has moved into a state of paralysis, with the Congress incapable of passing any sort of additional stimulus measures. This is not an arrangement we see changing anytime in the relevant future.
This puts the onus on the Federal Reserve to provide further stimulus to the economy. While short-term interest rates are already effectively at zero, the Fed can reinitiate the purchase of long-term assets to increase the money supply. It had been doing this up until the end of March, and we feel it had been highly supportive to the economic recovery up to that point in time. As conditions have since deteriorated, the fact that they have not continued with the purchase of US Treasury and mortgage bonds represents an effective tightening of policy. This makes little sense, and is one of the reasons the market came under further pressure following the release of the statement from the latest meeting of the Federal Reserve Open Market Committee on June 23. The committee said, in essence, that conditions had worsened but suggested no change in Fed policy as a response. Ultimately, we think the Federal Reserve will act if economic data continue to weaken. We are confident this action will have the desired effect of accelerating growth and supporting financial markets. However, the sooner this action takes place, the less ground it will have to make up, and the more effective it will be.
The implications for financial markets are single digit returns across the board. The stock market is fully valued at current prices; therefore, they will rely almost exclusively on profit growth for further appreciation. Considering that corporate profit margins are already near all time high levels, it is likely that profit growth will be limited to nominal GDP growth of 4% or so. When you add 4% to the current 2% dividend yield of the S&P 500, you are looking at a 6% long-run return. It is worth noting that our portfolios have higher dividend yields than 2%, thus giving you a built in advantage over the general market. Bond yields are already in the low single digits, and what you see is all that you will get. We continue to be bullish on gold as a hedge against the possibility of aggressive inflation and monetary turmoil if economic growth is unable to keep pace with debt accumulation. Due to increased market volatility, we are expanding are forecast for the S&P 500 trading range to 900 to 1200.