Recession fears and low stock valuations may be unfounded

Last week we saw some renewed hope for markets with better-than-expected U.S. GDP numbers and this week it has continued with buoyant ISM Manufacturing. The S&P 500 index was down 0.4%, the Euro STOXX 600 was up 4.6% and the Nikkei 225 Index was up 1.6% on the week. But as we rolled into the last quarter this morning, investors were hit by the harsh realities; Greece yet again missed budget targets, letting out the steam of risk assets such as stocks. So we head into a new week of volatile markets as investors will continue to get mixed economic data and bad news out of Europe.

It is time to let Greece off
While leveraging the EFSF may be possible, the hope of it solving anything structural is very limited. At best it might kick the can even further down the road but it is not the answer.

On the surface it seems like European politicians are caring for their Greek brethren but it is important to realise that every human being is acting in his/her own interest. On that premise it becomes clear that the true intentions of the leveraged EFSF are to protect the European banking sector that has let itself get into too much peripheral sovereign debt. The problem is that Greece will never be able to repay its debt with a contracting economy, forced austerity by creditors and a 1.5x debt-to-GDP.

We have now wasted two years in Europe trying to save Greece with the only outcome of creating suffering for the Greek people. We should instead acknowledge past mistakes of lending too much money to Greece at a too low an interest rate. The only sensible and viable solution is to let Greece default in an orderly way and focus the resources on the second line of defense, namely Italy and Spain.

The question is will the economy go into recession?
More and more economists are joining the ranks of the bears calling for a recession. While we are not blind to current developments and structural issues, an intelligent investor should always be careful not to call a recession prematurely. You do not want to be the guy calling a recession for two years before it happens - missing out on beta because you are scared of the economy.

Our macroeconomic models still predict a low probability of an U.S. recession and today's better-than-expected U.S. ISM manufacturing index (51.6 vs. 50.5) was in favour of an economic slowdown and not a recession. In addition, China's PMI rose for the second month - the best reading in four months - indicating Asia's largest economy is showing some resilience. But Europe still remains the big unknown and could be the trigger for a Eurozone recession if things turn ugly in credit markets. But if we do get a US recession, we expect it to be a mild one as gross private investments are still very low - levels not seen since 2003.

Looking at stock valuations it seems almost ridiculous if economic data does not start to deteriorate more as valuations are almost 30 percent lower than the average valuation in the previous recessions, not counting the Great Depression.

With classic low beta industries such as household products, electric utilities and beverages valued at close to par with high beta stocks, it seems increasingly difficult to find attractive value in terms of risk/reward in defensive plays. If you believe the economy is not going into a recession the most prudent positions right now is to buy a strategic portfolio of quality companies with low debt-to-equity, strong operating cash flow and a mixture of growth/value or high/low beta companies - and then hedge it with ETFs. In this way you lower the portfolio's risk and make alpha if your stocks perform better than the market in either direction.