Wednesday, August 3, 2011

What Should You Do Now?

The markets passed their verdict on Washington's work yesterday, and it was not pretty.

The S&P 500 declined by -2.5%. Since last week, when the noise over the federal debt ceiling reached a crescendo, the S&P has declined by nearly -6%, wiping out all of the market's gains year-to-date.

U.S. Treasury obligations, meanwhile, remain the investment vehicle of choice, as investors rush for safety. Treasury 10-year notes now yield 2.55%, matching the levels of last fall. More ominously, you have to go out at least 4 years in maturity to earn over 1% in the government debt market.

And there's more talk of recession.

So what should investors do now?

That's always a complex question, but let me offer a few thoughts.

First, recognize that the deal reached in Washington essentially accomplished nothing.

The $913 billion spending reduction that is being widely quoted is actually going to spread out over 10 years. In addition, roughly half of the cuts are scheduled to come from the defense budget, which I doubt will really happen.

Incredibly, tax rates are unchanged for all income classes. On a percentage basis, our federal tax burden remains at one of the lowest levels over the past few decades despite a budget deficit of $1.3 trillion for this year.

Put another way: there will come a time when federal fiscal policy will turn definitely restrictive, but not now.

Meanwhile, back in corporate America, things are actually not all that bad. Nearly three-quarters of the companies in the S&P 500 beat earnings expectations in the second quarter.

True, most company guidance was cautious, but this merely sets the expectations bar fairly low, which is what managements love to do.

Most analysts and companies I have heard recently indicate that business conditions are sluggish, but not anywhere close to the depths of the recession of 2008-09. Activity could slow significantly, of course, but for now we seem OK.

The S&P 500 is trading at 12x estimated 2012 earnings, and sports a 1.9% dividend yield. Dividend payout ratios are still very low, at 26%, meaning there is plenty of room for dividends to move higher even if business conditions are sluggish.

When you compare a dividend yield of 1.9% to the 5-year Treasury note yielding 1.2%, it seems to me that stocks are the better vehicle for most investors who can take a three to five year time horizon.

In short, my best advice for now: Take a deep breath. Washington is a mess, and we have serious problems ahead if we can't figure out a better way to govern. But hiding in a bunker at this point doesn't seem to make much sense.

And if you want to worry about something, take a look across the Atlantic Ocean at Europe. The eurozone is in full crisis mode, and the situation is not improving.

Or, to quote columnist Ambrose Evans-Pritchard from the London Telegraph:

"America is merely wounded, but Europe risks death."