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Emac's Bottom Line

Morgan Stanley: 'Mind-Numbing Volatility' Not Over Yet

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One of the smartest analysts on Wall Street is Douglas M. Cohen, of Morgan Stanley Smith Barney.

Here are his thoughts on the stock market:

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Most Top 10 lists are probably best left to late night television hosts. However, in this particular case, we thought we would share 10 of our big-picture observations related to the recent market turmoil:

1) To state the obvious, no one can possibly know what stocks will do over the next few days or weeks. At best, we appear to be pricing in a modest recession. At worst we are still in the early stages of a panic-fueled crisis of confidence as it relates to major governments and banks throughout the world (with Europe at the epicenter).

2) The market currently lacks confidence in Washington to save the day. The fear is that we are out of fiscal and monetary ammunition (the Feds seemed acknowledgment yesterday that they expect no legitimate recovery for at least two years did not strike us as particularly confidence inspiring). It may indeed take a crisis to bridge the wide fiscal chasm that was evident from the recent debt ceiling fiasco. This could be the crisis. The special bipartisan congressional committee that is charged with proposing a plan by November 23 has the potential to change the prevailing sentiment, although one wonders if continued signs of market panic will lead Congress to expedite matters, The Bowles-Simpson and Gang of Six proposals could serve as the basis of major structural changes to combat what both major parties view as an unsustainable debt path. Can they overcome the massive polarization in Washington? We are hopeful, but not confident.

3) Last Fridays S&P US credit downgrade was a sideshow, in some respects. It was probably the figurative equivalent of yelling fire in a crowded theater, but did not really say anything the market did not know. The timing, though, could not have been much worse, in our view, given how nerves were already on edge.

4) The European situation is still highly concerning. While the latest ECB buying has driven Italian and Spanish government bond yields down from their recent highs, the structural challenges regarding who will be left with exposure to the over-indebted peripherals (and increasingly parts of the core) remains largely unresolved. Cyclical indicators such as industrial production also appear to be slowing down markedly in the European core, making austerity measures all the more challenging. At the moment France's AAA sovereign rating appears to be in the cross hairs with pressures appearing in France's credit default swaps.

5) MS & Co.'s US equity strategist Adam Parkers view that the market could be in for a period of multiple contraction has proven right over the past few weeks. Despite generally strong earnings reports in the first half of 2011, the one-year forward P/E on the S&P 500 has declined to just below 11x today from 13x at the start of the year. Adam believes that a 10x multiple is possible. The historical norm for the recent interest rate and inflation environment is closer to 13x.

6) The Q2 earnings season was generally solid, with some notable exceptions among several industrial companies who telegraphed signs of economic weakness for the first time since 2009. With the great majority of companies having already reported, 2Q y/y EPS growth is running at 12% and is about 4% above expectations. Revenue growth has been strong at 13% y/y. Results are even stronger when looking at the S&P 500 ex-financials, with earnings up 22% y/y and revenues up 16%. The prevailing concern is that earnings could roll over in coming quarters as the global economy slows and margins face downward pressure.

7) Certain segments of the market such as the large-cap multinationals are offering relatively attractive dividend yields above current 10-year Treasury rates. Despite potential near-term deer in the headlights trepidation from Corporate America, the outlook for dividend growth is generally positive. With dividend payout ratios well below historical norms and cash-rich balance sheets, we expect dividend growth to outpace earnings growth in coming years and for investors to reward corporate managements that favor returning capital via dividends and buybacks.

8) The equity bull case as supported by the Morgan Stanley Smith Barney Global Investment Committee is that equities offer attractive valuations, strong balance sheets, good earnings growth and provide attractive value relative to very low yields on fixed income and cash. The GIC favors emerging market equities relative to developed markets.

9) We think that the "Global Gorilla" theme, loosely defined as high-quality multinational corporations with strong balance sheets, positive free cash flow generation, and defensible operating margins are trading at supportive valuations relative to the overall market and are the most compelling opportunity in the equity marketplace. These types of stocks have begun to decouple somewhat from the general market weakness of the past few weeks and also offer above-average dividend yields and leverage to a potentially weaker US dollar.

10) In our view, those who simply cannot tolerate excessive volatility should strongly consider reducing their equity exposure. The mind-numbing volatility is unlikely to be over. Longer-term investors with ample diversification and a Warren Buffett-like long-term disposition should likely look to buy into the recent correction.

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