Download PDF

Subscribe

June was a terrible way to end the quarter. With the S&P 500 Index down more than 10% over the course of the quarter, the market correction just got worse and worse. Treasury yields continued to drift downward as well. We think the two are related: stocks are pricing in low growth, and Treasury yields are reflecting that. While the yields and stock prices of the 1980s and 1990s moved in opposite directions (stocks were up while yields were falling), that activity was primarily driven by the disinflation of the 1980s. Now that inflation is tame—if not nonexistent—interest rates reflect expectations of low growth.

THE ECONOMY
Dis-employment continues, with disinflation (below-par inflation) and high unemployment. Things still seem to be in disarray in Europe, China is tightening the reins to tame inflationary pressures, and there is a growing divide between countries, with some calling for fiscal austerity and others calling for more fiscal stimulus. From our perspective, this is a “traders market,” where investors should practice “active diversification” by staying diversified but relying on active managers to navigate the volatility.

Not a Very Austere Austerity
Even though a lot of countries are calling for “austerity,” there is nothing very austere about some of their belt-tightening proposals. To us, it’s a simple matter of not spending money you don’t have. To developed world governments, however, austerity means still spending more than you have, just not as much as before. It’s a start of sorts, but certainly not enough to get us home.

The debate centers on whether now is the time to start reducing budget deficits. U.S. government officials seem to favor waiting on deficit reduction, while European governments seem to want it sooner rather than later. However, to us, it’s key to ask not just “when?” but “how?” Deficit reduction can come about through cuts in spending or through increases in taxes. From our perspective, whether there are cuts in spending doesn’t matter as much as whether there are increases in taxes. Austerity through spending cuts could be fine, while deficit cutting through tax increases could be devastating. Any country implementing austerity through the tax route will likely face a double-dip recession or just a prolonged period of stagnation.

Financial Regulation Is Like Tight Money
Another point of divide between central governments is to what extent there should be financial regulation. To be sure, there is already financial regulation—the question is, how much more should there be? As of this writing, the U.S. Congress was in the process of considering the compromise bill on financial regulation. The House of Representatives passed its version, the Senate passed its version, and the two had to be reconciled. The conference committee convened, deals were struck, and now the compromise bill needs to be passed by both houses again. The House of Representatives passed a version that removes the controversial bank “assessment” (it’s really a tax). The Senate will not likely get around to voting until after the Fourth of July holiday.

If the financial regulation bill passes as drafted, there could be significant fallout for the financial industry in the United States. And without coordinating any new regulation with other countries, the United States runs the risk of having more newly regulated financial activities move to “friendlier” environments.

Another notable feature of the proposed financial regulation is the requirement that banks hold more capital. While that sounds reasonable on its face, it’s tantamount to tightening monetary policy. Higher capital requirements mean banks cannot lend as much, or they may be more selective about to whom they lend. While the Federal Reserve is trying to keep monetary policy loose, higher capital requirements can undo that. In order to counter-balance higher capital requirements, the Federal Reserve may need to reinitiate quantitative easing. This tug-of-war between central banks and central governments will probably keep interest rates very low for an extended period.

Slow Growth With Low Inflation
Housing and inflation data turned weaker in May, but household incomes and spending improved and business spending stayed healthy. Consumer spending has been improving because incomes are increasing. Through May, personal income was up 1.6% from a year earlier—not a strong increase but a big improvement from the negative numbers last year. Spending is up 4.6% from a year earlier.

Inflation remains very tame. The year-on-year increase in the core Consumer Price Index is below 1.0%. With inflation this low and money and credit growth crawling along, we continue to expect the Federal Reserve to keep the federal funds rate near zero during the rest of 2010, if not until July 2011.

First-quarter gross domestic product (GDP) growth has been revised down to 2.7%, but second-quarter growth looks stronger, thanks mainly to manufacturing. Those data become available late in July. Early estimates call for a growth rate of around 3.5%. If sustained, that would be fast enough to pull down the unemployment rate, but at a plodding pace. These GDP figures should dispel fears of a double-dip recession scenario, but if there are tax increases at the end of the year, our opinion may change about the likelihood of a second decline.

EQUITIES
The difficulties the stock market experienced beginning in late April persisted through the month of June, as a plethora of domestic and global issues pressured equities into their first correction since the market rallied off its lows in March 2009. Among the many issues weighing on investor sentiment were sovereign debt concerns in Europe, financial reform legislation in the United States, and moderating growth in China, as well as the Gulf oil spill and a variety of geopolitical threats. Moreover, what had once been considered bedrock for the 14-month equity rally, the market’s technicals (price and volume patterns) broke down from their long-term trend seemingly just as the fledgling improvements in housing and employment took a turn for the worse, putting into question the extent of the economic and profit recoveries.

For the month of June, all the major market equity indices declined, exacerbating their poor second-quarter and year-to-date (YTD) returns (see Chart 1). The weakness last month was led by the Russell 2000® Index of small cap stocks and the NASDAQ Composite Index, areas that had been performance leaders during the market rally. While it’s still early, we suspect that this may be an indication that the market may place more of an emphasis on quality, as the expansion matures into a less spectacular pace of growth for both GDP and corporate profits. In addition to this “large cap versus small cap” dynamic recently playing out in the markets (with large cap simply being down by less), the performance differential between growth and value investment styles has also narrowed, with investors having apparently taken more profits from the value sleeve during June.

The challenges facing international investors were numerous during both the month of June and the second quarter, highlighted by the European debt crisis and concerns over credit tightening and currency revaluation in China. Given the potential for further debt problems in Europe, the developed markets index (EAFE) significantly underperformed the emerging markets index (EMG) for the quarter.

Finally, on a sector basis, the same cyclical industries that led the recovery also led the subsequent pullback, as weakness was particularly evident in consumer discretionary, materials, and industrials last month. The “risk-on, risk-off” trading pattern was perhaps most evident with the search for yield and perceived safety in the telecommunications, utilities, and health care sectors, which all managed to either be down less or experience slight gains in June.

	Market Performance		7-1-2010		Total Return (%)
	Equity Index Name		Level		June		QTR
	Dow Jones Industrial Average		9,774		-3.4		-9.4
	S&P 500 Index		1,030		-5.2		-11.4
	NASDAQ Composite		2,109		-6.5		-11.8
	Russell 2000®		609		-7.7		-9.9
	S&P 400 Midcap		711		-6.6		-9.6
	S&P 600 Small Cap		327		-7.1		-8.7
	S&P 500 Growth		531		-4.7		-11.3
	S&P 500 Value		491		-5.7		-11.6
	MSCI EAFE		1,348		-0.9		-13.7
	MSCI EMG		917		-0.7		-8.3
	Sector
	Consumer Discretionary		229		-9.7		-10.9
	Consumer Staples		262		-2.4		-8.1
	Energy		373		-5.7		-12.7
	Financial Services		185		-5.9		-13.3
	Health Care		326		-1.7		-11.8
	Industrials		238		-6.9		-12.3
	Technology		329		-6.2		-12.2
	Materials		172		-6.9		-15.3
	Telecommunications		102		-0.2		-4.2
	Utilities		143		-0.6		-3.7

Technical Difficulties
As mentioned above, the equity markets experienced their first correction (defined as a pullback of 10% from a recent high) since the rally began in March of last year. For the quarter, the S&P 500 Index declined by 10%, reacting to a combination of disappointing fundamentals, alarming debt crises, and weakening technical support. As the market declined in May and early June, the S&P 500 Index “broke down” from its longer-term trend; that is, the market’s price fell below that of its 200-day moving average (DMA). While momentum improved in the third week of June (see Market Update, “Starting Blocks,” 6-17-10), the S&P 500 Index weakened in the final days of the month, ultimately violating its major support level of 1,040 on the last day of the second quarter (see Chart 2).

Unfortunately, the market’s inability to hold above the level (1,040) that previously marked bottoms in February, May, and early June suggests the potential for further technical weakness. The next level of support remains in the 1,000 to 1,009 range. In addition, the interaction of the market’s 50-DMA (1,118) with its 200-DMA (1,112) is also poised to signal the extent of the next move. Yet we want to point out that other signals, such as new 52-week lows, are not consistent with previous sell-offs. In addition, areas considered “riskier” and “cyclical,” such as the Russell 2000 Index and the Dow Jones Transportation Average, finished the quarter above their February lows. Finally, the relative strength index for the S&P 500 finished the quarter hovering at levels that previously indicated oversold conditions. As the near-term technical picture remains precarious, we will continue to monitor all of these developments.

Second-Quarter Earnings Preview
Despite the technical challenges confronting the markets, we remind investors that the domestic cyclical strengths remain ample and are expected to generate operating profit growth for the S&P 500 Index of up to 35% for the second quarter (see Chart 3). Interest rates and inflation are low, productivity is high, and incomes are improving. Moreover, housing appears to be close to a bottom, with the Case-Shiller Home Price Index of the 20 major metropolitan areas showing a 3.8% improvement from this period last year. And let us not forget that approximately 40% of last year’s stimulus package is being put to use this year in areas such as infrastructure, sustaining growth in both economic activity and corporate profitability.

S&P 500 Index EPS	2Q 2010	2010
Sector	EPS % Growth Rate	EPS % Growth Rate
Consumer Discretionary	43.7	24.6
Consumer Staples	4.5	9.0
Energy	68.0	48.2
Financial Services	90.3	135.6
Health Care	9.2	11.8
Industrials	14.4	14.5
Information Technology	47.6	41.5
Materials	96.2	71.6
Telecom Services	-4.0	-2.2
Utilities	-1.5	3.8
S&P 500 Index	33.7	33.6

From a sector perspective, the global stimulus programs are trickling down the income statements of many leading international and cyclical industries, including energy, materials, and industrials. Consumer discretionary and financials are benefiting from low interest rates and easy comparisons from last year, while the technology sector is enjoying growth from demand for productivity related to capital investment. (It should be noted that while the final details of the financial reform legislation are still being worked out in the Senate, it is possible that the increased regulatory costs could reduce profits in the financials sector by up to 10% in 2011.) Considering the pace of the recovery over the past year, the EPS gains have been more muted in traditionally defensive sectors such as health care, staples, utilities, and telecom.

BONDS
A revival of the safe-haven bid for Treasuries was the primary force in the bond markets during the second quarter and a major influence on first-half returns. Despite a series of initiatives by the International Monetary Fund (IMF) and the European Central Bank (ECB), markets for the debt of several European governments remained unsettled throughout the quarter, prompting international investors to return to the relative safety of U.S. Treasuries. Additional concerns about slower world growth added to the demand for bonds in late June, sending the yield on the 10-year Treasury below 3% for the first time since the dark days of late 2008/early 2009. That rally pushed the 30-year Treasury to the top of the YTD return rankings, with a return of more than 15%. The bond yield dropped from 4.65% on January 1, 2010, to 3.88% at mid-year.

Steep yield curves were the next greatest influence on total returns. In every market sector, the longer maturities performed best. In the Treasury market, returns on bills were close to zero, and the 2-year note returned only 1.8%. Among investment-grade corporates, one- to three-year issues returned 2.5%, while maturities beyond ten years returned 8.7%. In the municipal market, the one- to three-year segment returned only 1.1%, versus a return of 3.8% for maturities of ten years and longer. Only the shorter high-yield maturities performed well, with a total return of 6.1%, versus a return of 7.8% for the longer maturities.

The second-quarter returns from high yield demonstrated again that this market is poorly correlated with Treasuries but highly correlated with equities. For much of the quarter, investors were sellers of riskier assets, including stocks and the riskier bonds. As a result, the weakest high-yield credits—those rated CCC and lower—had negative returns for the quarter. In the five previous quarters, those weaker credits outperformed the BB and B sectors by wide margins.

In the municipal market, however, returns were greater in the A- and BBB-rated segments than in the AAA segment. The BBB issues returned 5% over the past six months, versus a return of 2.4% for the AAA bonds. Despite almost continuous media reports of fiscal problems confronting state and local governments, investors are apparently convinced that the historical record of very low default rates on municipal debt will likely be maintained in this cycle.

The relatively poor performance by the municipal market in June was due, in part, to seasonally heavy new-issue calendars. Seasonal factors have typically been important in June. In ten of the last 20 years, municipal market returns have been negative in June. In July, however, returns have been negative only three times in the past 20 years. Investors typically receive a large volume of interest and principal payments around July 1, and the reinvestment of those funds typically helps the muni market perform well in July. The fact that municipal-to-Treasury yield ratios are again quite generous should also help boost demand for municipals in the month ahead.

THE BOTTOM LINE
The S&P 500 Index finished the quarter trading at just 12.5 times this year’s consensus ($82.50) earnings projection. Valuation measures relating market prices to book value, sales, and cash flows remain attractive, in our opinion, despite the current technical difficulties. Also, cash levels sitting in money markets are near historic highs, and money entering the short end of the Treasury curve continues to be rewarded with lower yields. We believe the ultimate endgame of this experience will not be deflation (as equity and bond investors currently appear to be pricing into securities), but rather, historically average inflation growth in the range of 3.0% to 4.0% by the end of 2011. Even given low rates and inflation, applying a historically average price/earnings ratio of 16.5 times our below-consensus earnings estimate of $77.50 for 2010 suggests that the market may be fairly valued in the 1,275 range by year-end. This may appear to be a stretch from current levels. But in a crisis, we look for bottoms, not tops. With this outlook in mind, we continue to favor equities over fixed-income, though fixed-income may provide a paltry return, as rates are likely to stay low. For short-term investors, return of principal may govern asset allocation decisions, while we believe long-term investors should continue to focus on return on principal.