Author: John Frankola, Vista Investment Management
Covestor model: Core Holding
Disclosures: None
The stock market, as measured by the S&P 500 Index, advanced strongly over the final four days of the quarter. Had the quarter ended a week earlier, the market’s first half returns would have been disappointing. The late quarter rally allowed the S&P 500 to end the first six months of 2011 well in the black, putting stocks on target for another good year.
However, it is best not to read too much into the recent performance. By the time you actually read this letter, the market could be up or down another 5%. What the late quarter move should remind investors is that the stock market is volatile and unpredictable in the short term. Not much really changed in the final week of the quarter. The Greek parliament approved another austerity program and European banks accepted a plan to rollover Greek debt. However, it’s hard to believe this event alone was the catalyst for the large move in the U.S. stock market in the last week of the quarter.
Continuing with the theme that the stock market is unpredictable in the short term, S&P 500 returns overall in the past 12 months show a strong recovery from last summer’s correction, which was attributed to the Gulf Oil Spill, the May 6 flash crash (a huge stock market drop during a 30-minute period), the European debt crisis, and the first Greek bailout. These problems, combined with weak economic data, led many investors to sell stocks last summer as they believed that the U.S. was headed into a “double-dip” recession. The sharp rally off the lows of last summer seems to indicate that many investors over-reacted to negative news last year.
While stock performance in the second quarter of 2011 was essentially flat, wide divergences in investor sentiment were clearly visible. The S&P 500 reached a post-crash high on April 29, but then fell sharply to a low point on June 15. Signs of speculation appeared in the hot IPO (initial public offering) market with LinkedIn and Pandora going public and with anticipated offerings from Facebook and Groupon. At the other extreme, risk adverse investors poured billions into bond mutual funds during the quarter, despite interest rates offering historically low yields.
The current list of problems for the economy is long. The pace of the US economic recovery is slow. In the first quarter, GDP grew at just 1.9%. Unemployment remains stubbornly high at 9.2%. The housing market is still bouncing along the bottom. The Federal Reserve’s second program (QE2) to stimulate the economy by purchasing Treasury securities ended in June, which raises concern that interest rates will soon rise. Congress has not yet dealt with the federal budget deficit or the national debt ceiling. Many state and local governments are experiencing significant financial problems. While the Greek situation has been temporarily resolved, many worry also about Portugal, Ireland, and Spain. Conflicts and uprisings in Asia, the Middle East, and Africa contribute to a high level of political and economic uncertainty and volatility in the energy markets.
While it might not seem like the best scenario for owning stocks, US companies are actually thriving in the current environment. Corporate earnings are very strong, and valuations for US companies appear to be reasonable. In addition, companies have significantly improved their balance sheets and now hold record levels of cash. These factors should result in higher dividends, share buybacks, and acquisitions of other companies – which should benefit equity investors.
Fixed income investments performed strongly in the second quarter as interest rates declined. The BarCap Aggregate Bond Index, which measures the performance of the taxable bond market, generated 2.3% returns during the quarter. The BarCap Municipal Bond Index produced 3.9% returns. The yield on the benchmark 10-year Treasury bond declined from 3.45% to 3.16% during the quarter. The decline in US interest rates and strong relative performance for bonds was generally attributed to concerns over a slowing US economy and the European sovereign debt crisis. With the likelihood that interest rates will eventually move higher as the economy improves and/or inflation increases, longer-term bonds appear to be somewhat risky (since bond prices decline when interest rates rise).
The results of the past quarter seem to demonstrate that the investment community has considerable skepticism about the ability of the US economy to continue its recovery. Indeed, many of the current problems, such as those related to government deficits and unemployment, will likely take a long time to resolve. However, most corporations have adjusted their business models so that they are able to succeed in the current environment. In this regard, equity investments appear to be relatively attractive for investors with long-term horizons.
John D. Frankola, CFA
Sources:
“Gross Domestic Product: First Quarter 2011 (Third Estimate); Corporate Profits: First Quarter 2011 (Revised Estimate)” Bureau of Economic Analysis. http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm
“Labor Force Statistics from the Current Population Survey” Bureau of Labour Statistics http://data.bls.gov/timeseries/LNS14000000
“Barclays Capital Commodity Index (BCI)” Barclays Capital. https://ecommerce.barcap.com/indices/index.dxml
