The stock market took no prisoners yesterday, August 4, as the Dow dropped more than 500 points, and only 3 of the S&P 500 stocks finished up for the day.  While we think the words panic and rout are too strong, it was disconcerting to say the least, and investors seemed to agree, as they were gripped with worry that the US and global economies were headed toward recession. 

While we concede that there is a lot to worry about—Europe’s debt crisis, the survival of the euro and the euro zone in general, anemic growth in the US economy, and China’s battle with inflation, to name a few—we still believe that the US economy will continue to grind out growth as we unwind the massive debts accumulated by the deficit spending during and in the aftermath of the mortgage crisis.  We believe yesterday’s selling was overdone. 

In what we hope will not become further precedent in years to come, 2011 has followed an identical pattern to 2010—strong first quarter, lousy second quarter, strong July, and lousy August.  In 2010, the August decline was just as bad, but a bit more gradual.  From August 4, 2010, to August 26, 2010, the stock market was down 7%, which was 13% off its high for the year and made the stock market negative by 5% for the year to that date.  As a result, fear of a double dip gripped investors.  This year, the stock market was even more dramatic with the Dow off more than 500 points yesterday, erasing all the gains of 2011 and leaving the Dow in negative territory year to date. 

The catalyst for the selling was Monday’s report of not only weaker than expected consumer spending in June, but an actual drop in consumer spending for the first time in two years.  Faced with continued high unemployment, no wage growth for those employed, “Armageddon” rhetoric on the debt ceiling debate and waning confidence in the future, consumers reduced spending.  Improvement in the stock market will only come as a result of improvement in those arenas. 

As a quick aside, no matter which side of the debt debate you find yourself, it is tough to argue that any of the offered solutions would do much to help an ailing economy in the short term.  Higher taxes, significantly reduced spending, or some combination of both, do not help a fragile economy.  The only relief in the mini-deal that finally passed was that there was a deal and the market shrugged off the relief immediately after it was announced.   Longer term, it is imperative that we find a solution course that will reduce the debt and improve consumer and business confidence.

The US has borrowed and spent money much in the same way that a consumer accumulates massive debt to finance houses, cars, and vacations in anticipation of future raises and promotions.  When the realization sets in that the outlook for the future was way too optimistic, and what exists is a steady job with no raises in sight, there is little to do but grind it out.  The prescription would be to pay down debts and spend less.  We feel the same way about the American economy.  The US will have to grind it out without much further help from the government slowly paying off debts and kicking its spending addiction.

Our outlook is that this will happen without falling back into recession—with slow, imperfect growth, not without fits and starts.  Companies that sell into overseas markets that use available cash in enterprising ways should see their stock prices rise, and there are still opportunities for investment in such companies. It will not be easy and there will be setbacks, but we believe the stock market remains a good investment. 

Of course, confidence is a fickle thing, and one of the most important factors driving economic health is confidence in the future.  Yesterday is a good example of what happens when confidence is shaken.  On days when confidence in the market comes into question, there can be considerable price drops, as there were yesterday.  We still maintain that contrary to sentiment that may exist among some, we are not headed into another 2008, but rather will emerge from this soft patch, albeit a long one, with a slowly climbing economy.