The Best House In A Bad Neighborhood?

I have not changed my equity exposure, which is 30% of financial assets. However, several developments merit discussion.

The deleveraging in Europe has reached a critical stage. Often when very difficult decisions have to be made, they are postponed until forced upon them by the markets. "Necessity is the mother of invention!"

Two unpleasant steps have to be taken. To keep the EU intact, the strongest nation, Germany, ultimately must pay a price in order to absorb the effects of the weakest nations' profligacy. Such action lets these nations off the hook and encourages future bad behavior, which is anathema to the German psyche. But at the same time, the EU has been a boon to German exports, and perhaps Germany can suspend their antipathy toward bailouts for their own better economic well being -- a calculated cost-value decision. In the Fall of 2008, two anti-moral hazard leaders, Paulson and Bernanke, persuaded the U.S. Congress to enact TARP, essentially bailing out profligate U.S financial institutions. I wrote about this in a post entitled "Scared Straight!"

The second step is setting up a fiscal governing body for the EU or EC, one with teeth. Such a body could force fiscal discipline on any member until desired levels of budget deficits and debt are reached and maintained. If a member doesn't comply, the penalties must be severe--with expulsion from the community a possibility. Chauvinism runs high in Europe. Getting seventeen nations to agree on this may be extremely difficult.

If the European Central Bank is satisfied that movement toward resolution of this crisis conveys both sincerity and a sense of urgency, it is likely to lower interest rates.

For certain, even the best outcome entails austerity. The European economies in aggregate are larger than our economy. Europe is teetering on recession, and may already be in one.

With respect to China, the Central Committee is attempting to dampen inflation without causing too great a slowdown in growth--a "soft landing." Whether such an outcome can be achieved is yet to be determined.

The U.S. is now the "best house in a bad neighborhood." Our aggregate equity market is up slightly for 2011 thus far, while all other major equity markets are down significantly. While our growth continues to be subpar, recent economic stats, particularly a lower trend in unemployment claims and a gradual increase in private employment, point to no imminent recession. While real incomes remain flat, consumers apparently are dipping into savings during this Christmas season, with retail sales surprisingly robust so far. When asked, as many as 40% say they will spend less this Christmas and 70% plus don't plan to borrow more to pay for Xmas gifts. However, one should never underestimate the U.S. consumer's propensity to spend. Watch what they do, not what they say!

In any event, the risk of outright recession in the fourth quarter has receded. Whether our economy can decouple from the rest of the world for much longer is questionable. The highest probability is that the U.S. economy continues to muddle through with subpar growth. The next most probable event would be recession, with the imminent attainment of "escape velocity" the least probable.

An interesting question is whether the U.S. economy can reach escape velocity before our own austerity measures kick in. The passage of time favors resumption of normal growth because pent-up demand for new cars and new homes is building. At some point these factors will overwhelm deleveraging effects. On the other hand, after the November 2012 elections, we must deal with our own federal debt and deficit issues. Like Europe, this entails austerity, or lower GDP growth.

Achieving escape velocity would mean 3% to 3.5% real growth in GDP over several quarters without the aid of additional fiscal or monetary stimulus. The discounting of that event would trigger a massive rally in the S&P 500 Index, regardless of its overvaluation at that time.

At this juncture, the S&P 500 Index is slightly overvalued at 1260. Fair value for 2012, based on normalized earnings growth and interest rates, is 1150 to 1200. For those of you unfamiliar with my methodology, I suggest you read my posts entitled "The Seven Percent Solution", written March 15, 2007, and "More Stimulus Or Else" with the subheading "Valuation Metrics", written June 28, 2010.