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Crisis in Japan

S&P 500 Daily Chart

The crisis in Japan is a terrible thing. The loss of life and property are huge and will impact those living there for a long time to come, much like the 911 attacks impacted the US. The real question is whether it will impact the rest of the world the way the 911 attacks did.

In the chart above, you can see that the impact on our own stock market has been significant, but that we are currently trailing upward. There are several questions that we are trying to figure out, like: (1) will this have a significant impact on world economic growth going forward, (2) will it impact corporate earnings, (3) will it change the investment landscape such that the companies with growing earnings as reported in the most recent quarter will no longer have growing earnings, (4) will there be other market leaders coming out of the current crisis-induced selloff such that we need to make significant changes to client portfolios (focusing on “defensive” stocks instead of earnings-growth based stocks), or (5) will there be worldwide impacts to daily life beyond Japan.

Investment Guru Doug Kass wrote this today which helps to answer (1) above:

In rough terms, the Japanese economy represents one-tenth of the world’s GDP and about one-third of U.S. GDP.

Let’s guess that the Japanese economy suffers about a 1.5% hit to growth, bringing real GDP growth for 2011 to approximately flat year over year. World GDP will therefore be cut by only about 0.15% this year. (Estimates are that this would lower real GDP growth in the U.S. by about 0.4% and the eurozone by about half that amount.)

The current multiplier to profits of a 0.4% drop in U.S. GDP is roughly 6x-8x, bringing 2011 S&P 500 profits down by about $3 a share (7 x 0.40%). The $3 reduction in S&P earnings, using the pre-earthquake P/E multiple of about 13.5x, produces about a 40-point diminution in the value of the S&P 500.

The S&P sold at about 1325 the day before the Japanese earthquake. Forty S&P points taken from 1325 brings the intrinsic or “fair” value (based on the above analysis) of the S&P to about 1285, or about 22 S&P points above the current trading level. So, with S&P futures down by about 36 points now, most of the Japanese disaster seems to now be discounted, unless it morphs into a broadening nuclear disaster.

If the market is in the process of finding a bottom as Doug states, and the impact to worldwide GDP is as limited as indicated, then we can infer answers to the other questions as follows:

(2) will it impact corporate earnings? yes, but it seems as if it is priced into the market if the analysis is correct,

(3) will earnings growth cease? unless there is a major change to the investment landscape, the companies that have been seeing growing earnings should continue to see growing earnings – UNLESS there is a worldwide impact from a nuclear disaster,

(4) will there be new leaders to the market? there is no way to know right now if there will be new market leaders – you see companies like managed health care companies moving higher today because people are reacting to the news and assuming we will have a global recession – however, the analysis just doesn’t support it nor does history (we didn’t have a worldwide recession after the Japanese quake in 1995 which was also devastating – we may have a period of time where those defensive companies outperform, but making wholesale switches to strategy based upon a reaction and no data nor historical precedent is careless and not something we do, and

(5) will the crisis impact the entire world or just Japan? this crisis, as terrible as it is, is not the financial market collapse we saw in 2008 which put the entire world’s financial system in jeopardy nor the 911 attacks which started the Afghanistan and Iraq wars that have involved many countries to varying degrees – the likelihood is that it will negatively impact Japan for a few years, marginally lowering global economic activity, but will not in and of itself throw us into a global recession.

The biggest risk to the markets is still whether the Federal Reserve will end its accommodative monetary policy – going into the Japan crisis, you had already begun to see that some investors were selling some of my favorite areas of the market that have good long-term catalysts (small/mid-cap growth stocks, emerging markets, technology and basic materials) in favor of consumer stocks like McDonalds and P&G. These shifts last awhile – it will probably be until a combination of the next earnings announcements and actual action by the Fed.

My best assessment is that the Fed will not be able to tighten monetary policy – they may even have to continue to purchase treasury securities to fund our deficit. This is based upon the fact that their current stated reason to have an accomodative monetary policy is to increase employment via an increase in wealth (ie, keeping monetary liquidity flowing to support the stock market and drive stock prices higher, generating a “wealth effect” of making people feel better about their financial position and more likely to hire new staff). The current pullback needs easy monetary policy to continue, plus Japan is the third largest purchaser of our treasury securities. If their resources are going into rebuilding after the disaster, the Fed may by default have to continue buying treasury securities – and as we’ve seen the proceeds of those purchases have moved stocks and commodities higher.

In Summary: At this point, we are working under the premise that the stock market is near a bottom based upon the analysis of impact to GDP presented above. That bottom will not impact the long-term growth in earnings we are experiencing due to the economic rebound from the financial crisis. However, we are paying attention to whether anything happening in Japan (like a nuclear disaster with worldwide implications) would impact the broader world. The real impact to the financial markets is the actions or anticipated actions of the Federal Reserve ending an easy monetary policy – and right now we do not see that they can do that.

As the crisis passes and we take actions in client portfolios, I’ll be back to advise you what is happening.

Mark