Time for a Pause

Uncertainty has finally caught up to the equity markets around the world and we shouldn?t be surprised. At the beginning of the year, most investors were optimistic about the outlook, partly as a result of the quantitative easing begun by the Federal Reserve in the fourth quarter of 2010. Much of the liquidity that poured into the system found its way into financial assets rather than the real economy.

Even though a number of events that would be considered negative for equities took place in the first four months of the year, the indexes moved higher.

The market was able to withstand the 9.0 (Richter scale) earthquake in Japan and the resultant tsunami, the Fukushima-Dai-ichi nuclear accident and related manufacturing disruptions, floods in Australia, severe winter weather in the United States, regime change in Egypt and Tunisia, civil war in Libya, a sharp rise in oil and other commodity prices, major credit problems in Greece and Portugal again casting doubt on the viability of the European Union and the euro, the possibility of a government shutdown as a result of hitting the debt ceiling in the U.S. and an inability of Congress to reach a compromise on cuts in the Federal budget.

Finally, however, the optimism began to wane. We have learned that the best time to buy stocks is when most investors are pessimistic. Points of extreme pessimism in terms of investor sentiment most recently occurred in March 2009 and August 2010, both important buying opportunities for U.S. stocks. As investor confidence improves and cash is employed, equities can have a sustained move.

If investors are already positive, as they were at the beginning of 2011, stocks can still rise but it is likely that the energy of the market will dissipate and a correction will begin before too many months go by. The decline will be blamed on the factors that the market successfully plowed through during the upswing.

The question then becomes: How vulnerable is the market and how far down will stocks go? Sentiment seems to be turning. Some survey-based indicators which were very optimistic (and therefore negative for the outlook) have shifted to neutral and the transaction-based Chicago Board Options Exchange put/call ratio is approaching a bearish reading which is favorable.

It is my view that the current market pullback was inevitable and is not indicative of a reversal of the positive move in equities that began last September. I still believe the basic underlying fundamentals are constructive. The U.S. economy grew 1.8% in real terms in the first quarter and I think forces are in place for real growth of 3% or more for the remainder of the year.

There are three principal factors driving the growth: exports, capital spending and the consumer, and they are still in place, although perhaps not as robust as they were a few months earlier. The first quarter real gross domestic product report showed equal 1.5% contributions from the consumer and private investment. For the consumer, durable goods (primarily automobiles) and services made equal contributions of .7%; for private investment, equipment and software provided the largest share, much of it for productivity-improving devices. Net exports were a disappointment. Although exports were reasonably strong, the increase in the price of oil resulted in a small net loss for the category.

A number of observers are worried that the end of quantitative easing (QE2) will result in a sharp slowdown in the economy and a resultant market decline. While I believe the withdrawal of liquidity might contribute to the correction running its course, converting the optimism of the beginning of the year to concern or

pessimism, I do not believe we are at the start of a prolonged market decline or the beginning of a recession. The negatives are well known: the rise in the price of oil has drained some consumer spending capacity; the slow decline in the unemployment rate has also deprived the economy of the buying power of more people finally at work again; the tightening of credit in the emerging markets to dampen virulent inflation has diminished demand for imports by those countries from the developed world; and uncertainties related to the viability of the European Union as a result of the possible default of sovereign credit in Greece, Portugal and Ireland have unsettled investors everywhere.

The turbulence in the Middle East and North Africa confused investors as well. While many cheered the coming of the Arab Spring, it is not clear that democracy will thrive under the new regimes. One thing we do know is that oil production in Libya has stopped and the world no longer has access to the 1.5 million barrels a day that were being produced there. Events in Europe, North Africa and the Middle East have driven investors looking for a low-risk place to put their money into United States Treasury securities. The yield on the 10-year note is approaching 3% as fear capital from everywhere floods into America. Concern about slower growth in the U.S. economy has created a ?risk off? attitude among domestic investors as well.

Byron Wien is Vice Chairman of Blackstone Advisory Partners LP.