Market Insight - July 2010
Financial markets stumbled badly in May and June. Stocks lost momentum after four consecutive quarters of advances, and short-term investors fled to gold and bonds. Is this a temporary retrenchment in the midst of a bull market, or something more serious? As April came to a close, investors remained enthusiastic, but volatility had increased and stock prices seemed to have gotten ahead of themselves. A correction seemed likely, and we got it in spades.
However, there were some other, more unsettling developments, mainly the collapse of confidence in the Euro. The Euro lost 11% in value during the second quarter, almost touching the $1.18 per dollar rate where it began trading back in 1999. European finance ministers gave us a crash course in how not to handle a crisis; by the end of June banks were warily eyeing each other's balance sheets, and fear of sovereign debt default had begun to drive markets downward. It bore an uncomfortable resemblance to the state of the US banking system in the fall of 2008, when confidence began to ebb away and markets locked up. Risk shy investors ran for the hills.
The Economy... Jobs and housing turn the V to W?
The sharp V shaped economic recovery over the past year seems to have stalled, or at least lost momentum, as economic numbers in June began to miss their mark. The temporary boost of employment by the US census bureau ended, and the non-farm jobs numbers fell in June by 125,000. A meager 83,000 private sector jobs were added, far fewer than the nearly 200,000 added in April and May. The economy is 7.9 million jobs short of where it was in December 2007. It is still moving in the right direction, but very slowly.
Building permits fell 5.9% in May; more troubling were single family housing starts, which fell 17.2%, the largest decrease since 1994. While much of this was the result of the expiration of the Federal housing tax credit for new homebuyers, sagging consumer confidence and falling prices trumped historically low interest rates as the driving force for the housing markets.
The Dow ended the quarter at 9,774, a loss of 10% for the three months ending 6/30/2010, and 12.8 % below its high point on April 26th. The S&P 500 lost 11.9% for the quarter, closing at 1,030.71. Money continued to pour into precious metals; gold gained 11.7%. The Russell 2000, a measure of the performance of the stocks of smaller companies, was off 10.2%. The EAFE MSCI index of developed global markets was down 13.25% year to date, while the MSCI developing market index lost 8.75%. The only bright spots were in the bond and fixed income market. The Vanguard intermediate term taxable bond fund gained 7.36% year to date, while the Vanguard investment grade and high yield tax free funds rose 2.77% and 3.7% after tax, respectively, for the year to date. Cohen & Steers Realty Fund eked out a modest gain of 1.91% for the first half of 2010.
There is little consensus among economists; rarely has the range of expectations for the economy and the market been so wide. Should our attention be focused on cutting the looming deficit, or should we be concerned that the economy is weakening and needs further stimulus? That the recovery has slowed is evident; whether or not we are headed for a double dip recession is far from clear. The greater risk now is in Europe; every hint of trouble there reverberates on our financial markets and poses potential risks to our economy. Despite recent social upheavals in Greece and general unhappiness at the cuts in social services that European governments have undertaken, the 750 billion Euro bailout package and recent successful debt auctions in Spain and Portugal have lessened the likelihood of default, but not erased the fear.
However, here in the US, industrial production and productivity remain strong . The Fed's accommodative monetary policy would suggest a commitment to a slower more sustainable recovery. Unfortunately the debate in Congress is currently framed by the extremes of the deficit hawks on one hand and the profligate stimulus spenders on the other.
The case for value in the market now
The last six weeks have been extremely disheartening, and have dampened investor’s appetite for risk. But we don’t think we are teetering on the brink of another recession or an extended bear market, and the case for investing and remaining invested is strong and compelling. The broad market, measured by the S&P 500, is selling at 19.7 times its combined 2009 earnings of $51.86, and only 12.5 times its estimated calendar 2010 earnings of $81.73. If investors and consumers regain confidence, we could reasonably expect a moderate rise in the PE ratio, say, to 15.7, its historical median. That would put the S&P500 at nearly 1300 by the end of the year, a more than 24% gain from today’s levels.