The second quarter brought welcome relief to harried and stressed equity investors around the globe as stock markets continued the advance that began on March 9. In the U.S., the Dow Jones Industrial Average advanced 11.0%, the Standard & Poor 500 Index rose 15.2%, the Nasdaq Composite climbed 20.0% and the Russell 2000 surged 20.2%.The financials were the best performing stocks followed closely by energy and materials.The other big winner was technology stocks which benefited from the belief that companies around the world will be looking for ways to enhance productivity in a highly competitive marketplace.Interestingly, the perpetual race between growth and value disciplines was a neck and neck contest in the quarter.For the full three months, value narrowly bested growth across all capitalizations – large, medium and small.
While U.S. investors enjoyed solid returns, the truly impressive results were confined to emerging markets with India up 62.9%, Brazil up 41.1%, Hong Kong up 37.3%, and China up 36.1%.Other significant gains were seen in Eastern Europe with Budapest rising 38% and Poland up 23%.Additional advances were turned in by major bourses with Japan up 23%, the United Kingdom up 25%, Germany up 18% and France up 12%. Overall, the second quarter represented a global sigh of relief as investors concluded that the world economies were not going into a death spiral.
Although the equity markets turned in generally good to excellent results, the fixed income markets portrayed a somewhat different picture.For example, corporate bonds and asset backed securities staged impressive rallies as investors felt more comfortable taking on increased risk.These instruments recovered to levels not seen since the financial crisis of last September.Specifically, investment-grade corporate bonds had a total return of almost 11% for the quarter according to a Merrill Lynch index.The gap or yield differential between these bonds and those of Treasuries plummeted to 3.3% from 6.0% at the end of March. In contrast, investors who sought the safety and comfort of Treasuries did not fare nearly as well with long term Treasury notes and bonds showing a decline of 3.0% for the quarter and a year-to-date decline of 4.4%, the worst six months performance in the history of Merrill Lynch’s Treasury Master Index which dates back to 1977. Importantly, the benchmark 10-year Treasury lost approximately 6% for the quarter with its yield rising to 3.52% on June 30 from 2.69% at the end of March (and 2.08% on December 31, 2008).
Significantly, high yield or “junk” bonds which have speculative-grade (below investment grade) ratings, had a blockbuster quarter with a return of about 23%. Powering this advance in junk bonds was a narrowing of the spread over Treasuries to 11 percentage points by June 30 from 17.6 percentage points at the end of March.Finally, according to Freddie Mac, mortgage rates rose in the quarter reaching 5.59% in mid-June from 4.85% at the end of March although they ended the quarter at 5.38%.
As the third quarter begins, it is important to assess the recent stock market rally and relate its action to corporate profits and economic fundamentals.Following the market bottom on March 9, expectations were so low that stocks rose on news that economic indicators such as manufacturing activity or the service sector were shrinking less than had been feared.At the time, investors didn’t require signs of actual sustainable growth in order to justify the purchase of equities.At its low, the S & P 500 Index was trading at approximately a 10 P/E based upon analysts’ estimates for the coming year. However, after a rise of almost 40% in three months, the S & P was trading at 14 times forecast earnings and no longer looked like such a bargain.With concerns about when the U.S. economy will show real signs of recovery as well as the actual shape of the recovery, investors are currently worried about second-quarter corporate profits due out in mid-July.
With this as background, now is a critical time to examine the U.S. economy to ascertain whether or not the monstrous $787 billion stimulus package enacted by Congress earlier this year is producing the desired results.So far, the jury is still “out” on this issue.While the stimulus bill was being hurried through Congress there were assurances by the Administration that unemployment would be held down to 7% with this program.Already, just a few short months later, the unemployment rate is already at 9.5% (a 26-year high) and will very likely rise into the double digit area within the next few months.Many, if not most, economists believe another one million workers will lose their jobs over the next twelve months with unemployment topping out sometime in 2010.
Although the economy is showing some early signs of stabilizing at very low levels, the shape of the expected economy recovery is being hotly debated by many well known economists. Specifically, the shape of the recovery has been variously described by the letters V, U, L and W with a very recent addition being the square root sign (a weak recovery that flattens out with little or no growth).To date, the economy appears to be headed for negative second quarter growth of perhaps 1.0 % to 1.5% which would be a significant improvement over the first quarter’s decline of 5.5%.Should the second quarter have negative growth, it would the fourth consecutive quarterly contraction, a stretch of decline that hasn’t occurred since the Great Depression of the 1930s. Meanwhile, the Federal Reserve has promised to continue to keep short term interest rates at the present zero to 0.25% level for an extended period while also maintaining its program of purchasing U.S. Treasuries and mortgage instruments designed to keep rates as low as possible to foster economic recovery and assist in a housing recovery.While these efforts may be impressive to some, there is another belief that the government’s fiscal and monetary measures are quick fixes but not a cure for the economy, akin to putting a lot of band aids on a compound fracture.
One of the most important drivers of the U.S. economy is the consumer.While it is true that consumer confidence has risen over the last several months (but retreated somewhat in the most recent month), it must be remembered that the consumer accounts for two-thirds to 70% of all economic activity and their confidence andspending plans are critical to the recovery.Despite the rise in consumer confidence from very low levels, the consumer is still concerned about the stability of their jobs. This concern has manifested itself in a rising savings rate.In the most recent report, the saving rate hit 6.9% compared to a zero savings rate one year ago.Economists are at odds over whether this rapid rise in the saving rate represents a long term shift in consumer behavior.There are some economists who believe the savings rate will gradually rise to 10% before stabilizing.Coincident with this change in savings pattern, the consumer is also paying down debt as part of a wide spread deleveraging of their personal balance sheet.If these actions are not transitory, the result will be a very weak economy recovery marked by slow growth in corporate profits.
Another area of ongoing concern is the housing market.While there have been a few scattered signs of stabilization in home prices, there is a general belief that the housing market will likely be moribund until the middle of 2010.Adding to the poor outlook are the large number of upside-down mortgages, the continuing large number of mortgage defaults and foreclosures and the lack of any coherent plan to address this problem.Making matters worse has been the rise in 10-year Treasury yields this year from approximately 2.08% on December 31, 2008 to a mid-June high of 4.0% (and ending the quarter at 3.59%).As Treasury yields rose, mortgage interest rates also rose and caused a sharp decline in mortgage refinancing activity. Of course, rising mortgage rates also threaten the recovery in the housing market.Although the Federal Reserve has been buying Treasuries in an effort to keep mortgage rates low, too much buying by the Federal Reserve can raise investor concerns about the inflationary ramifications of so much financing.
With regard to inflationary concerns, commodity prices have risen sharply this year with oil prices up 130% from their low in late 2008 to their recent high in the low $70s per barrel in early June.No one needs a reminder that rising energy prices act as a hidden tax on the consumer, sapping his purchasing power which could be used on other necessities while also adding to the costs of virtually everything purchased by the consumer.While there are many reasons to be concerned about the return of an inflationary environment, many economists find comfort in the low level of capacity utilization in the U.S. manufacturing sector.With plenty of slack in the economy and the high (and rising) unemployment rate, there is some justification for this point of view.However, the argument can still be made that rising inflation is the inevitable outcome of the immense amount of government stimulus being pumped into the U.S. economy. To add to the pressure, most of the major countries around the world have embarked on similar stimulus programs to assist their ailing economies.The result of this combined effort to reinvigorate the world economy is an increased risk that the world will be confronted with an inflation problem within the next two to three years.
Just the aforementioned fiscal and monetary stimuli are cause enough for worry.However, added to this mix are the huge budget deficits being created by the Obama Administration.For example, the last year of the recent Bush Administration, the fiscal deficit hit a record $450 billion.This year, the first year of the Obama Administration, the fiscal deficit will be at least $1.8 trillion.Amazingly, while there was considerable criticism of the Bush Administration budget deficit, there has been little if any concern expressed about the size of the current deficit.Furthermore, under the current Administration’s plan, the accumulated budget deficit of the U.S government will double in the next five years and triple in the next ten years. While there has been little said about this, there are legitimate concerns about the long term viability of such mindless spending as well as the possibility that such spending threatens to bankrupt the U.S.
Another area of significant concern is the intrusion of the government into the business community.Currently, the government owns and/or manages major entities in the banking (e.g. Citicorp), insurance (e.g. AIG) and automobile (e.g. General Motors) industries. As part of controlling these companies, the President has recently named a pay czar with sole discretion to set executive compensation at these firms. While few wish to acknowledge the fact, government control of these firms is a form of socialism that is at odds with the free enterprise system.These actions and the events surrounding them have moved with such swiftness that few if anyone is given the time to rationally consider what is happening to our economic system. If allowed to go unchecked, our way of life in the U.S. will be changed in ways that can only be described as frightening and profound.Additional threats on the near horizon are the energy bill (aka “cap & trade”) working its way through Congress and the universal health care plan being aggressively pushed by the President.The energy bill will raise prices for every consumer in the U.S. and will do little to limit the emission of greenhouse gases.The health care bill has a ten-year cost of somewhere between $1 trillion and $1.6 trillion depending upon which version of the bill is enacted.The health care bill has no current funding mechanism to pay for its outrageous costs which ultimately means higher taxes for all consumers.
To summarize, the corporate bond market (especially the high yield sector) has had a tremendous rally and no longer appears as attractive as it did earlier this year. The U.S. Treasury market is even less attractive as the huge amount of debt issuance will keep constant upward pressure on rates.If one is interested in purchasing U.S. Treasuries, buying should be focused on TIPS (Treasury Inflation Protected Securities).In a similar vein, the equity markets have come too far, too fast. While the stock market had an impressive advance to early June, the internal condition of the market has been deteriorating for several weeks. Leadership has narrowed markedly in June and volume has declined noticeably. Average daily trading volume has declined from 7.21 billion shares in March to 5.14 billion shares in early June.As a reminder, new bull markets are characterized by expanding trading volumes and gains are spread among a broad group of stocks.Consequently, this market increasingly looks like a rally within a bear market. As such, it appears likely that the market will give back a good portion of its recent gains and could conceivably make new lows later this summer or early fall (September/October).The next test for this market advance will be corporate earning season which begins in a matter of days.While the market could get through earnings season reasonably well, there will be many more tests for this market in the months to come.Importantly, the shape of the economic recovery and its impact on corporate profits will play an important role in determining the ultimate direction of this market over the remainder of the year. At the present time, caution should be the operative word while investors await a more attractive entry point into the markets.