The third quarter was a surprising one in many ways as the stock market continued, with only minor interruptions, the advance which began in early March. For the period, the Dow Jones Industrial Average (DJIA) and the Standard & Poor’s 500 Index (S & P 500) both rose 15.0% while the NASDAQ composite advanced 15.7% and the small capitalization Russell 2000 Index climbed 18.9%. Significantly, the advance by the DJIA was the biggest quarterly gain since the fourth quarter of 1998 and its best third quarter since 1939. While these statistics are impressive and a welcome relief after the carnage of the past two years, the international bourses did even better with the following gains: Australia 31.9%, Brazil 29.0%, France 27.0%, Italy 26.7%, Russia 26.3%, Spain 26.0%, Germany 24.1% and even the United Kingdom 17.2%.
Looking at the bigger picture, the DJIA is up 48% from its March 9 low and ahead 11% for the first nine months but still 31% below its October 2007 record high. In a similar fashion, The S & P 500 is 56% above its March low, ahead 17% for the year-to-date but still 32% under its October 2007 zenith. Among other highlights for the recent quarter, financial stocks were the best performing group in the S & P 500 gaining approximately 25%, followed by materials up about 21% and consumer durables up about 19%. Small capitalization stocks continued to perform well as the Russell 2000 is now up 78% from its March low. A noteworthy feature of the rally is that the weaker (riskier) companies have had the greatest upward moves.
Regarding the fixed income markets, high-yield, low-rated or junk bonds were the best performing segment of the market gaining 15% for the quarter according to Merrill Lynch. For the first nine months of the year, junk bonds gained a record breaking 48%. In contrast to those returns, investment grade corporate bonds recorded gains of approximately 8.3% and a U.S Treasury index advanced 2.1% for the quarter.
Turning to the economy, the third quarter showed signs of improvement after four consecutive quarters of economic contraction. While preliminary figures will not be available for several more weeks, a consensus of leading economists expects Gross Domestic Product (GDP) grew about 3% for the quarter, which would be the fastest in two years. Although this would be a welcome recovery from the severe contraction evident in the first quarter of 2009, the numbers are a little misleading and require further explanation. Undoubtedly, GDP growth was pushed higher by the $3 billion “cash-for-clunker” Federal program which provided a much needed shot in the arm to the ailing automobile industry. Then, the housing industry benefited from a Federal tax credit available for first time home buyers which will expire in November. And last, exceptionally low inventories that required restocking was also a help in the period. Outside the automobile and housing sectors, which were artificially stimulated, final demand continues to look anemic.
With a weak and uneven recovery very much in evidence as the fourth quarter begins, the economy is at risk of another period of weakness. While this outcome is not assured, most economists are expecting slower GDP growth in the fourth quarter than in the third quarter. Already, the automobile industry has reported a return to the very slow sales pace which was characteristic of the industry just prior to the “cash-for–clunker” program. And while the housing industry has shown some signs of stabilization, it remains vulnerable to another slow down following the expiration in November of the Federal tax credit for first time buyers.
As always, the key to a sustainable economic expansion lies mainly with the U.S. consumer. With approximately 70% of economic activity attributable to retail sales, consumers need to increase their spending levels. However, so far, consumers continue to spend cautiously due to concerns for their jobs and the need to have a larger savings cushion to protect themselves against future economic contractions. As part of this seemingly new consumer attitude, the personal savings rate has been climbing steadily this year and the reduction of debt levels is in full swing. There is considerable evidence that the deleveraging of consumer balance sheets is an ongoing phenomenon that probably will take years to complete.
Another important segment of the economic picture is the monthly unemployment report. In September, an additional 263,000 jobs were lost (the 21st consecutive month of job losses and the longest streak since numbers started being reported in 1939) and the reported unemployment rate rose to 9.8%. While this figure is a sobering one, there is a supplemental figure which makes for an even more frightening image. Specifically, if laid off workers who have settled for part-time work or have given up looking for a new job are included, the “real” unemployment rate stands at 17%, the highest on records dating back to 1994. In addition, most economists expect the official unemployment rate to creep higher for the next six or more months with a peak rate in excess of 10%. While it is widely understood that unemployment is a lagging indicator and normally continues to rise well into an economic recovery, the slow growth of this economic recovery is likely to restrain the decline in unemployment for a longer than normal term, In doing so, the consumer may remain concerned about job security and/or worried about finding a new job. As a result, consumer confidence may not rebound quickly and may contribute to more conservative spending and saving habits for some time to come.
Another facet of the economic picture is the declining value of the U.S. dollar in the currency markets. With the dollar losing value for several months, there is rising concern that the large central banks of China and Japan may curtail their purchases of U.S. Treasuries. However, an analysis of the situation reveals that China’s central bank has already diversified its foreign currency reserves and needs to continue purchasing U.S. Treasuries simply because there is no other market large enough to handle the sheer size of their buying program. Another aspect of the dollar’s recent weakness is foreign trade. Currently, many countries in the European common market and elsewhere have already started to recover from the economic downturn and, with their currencies stronger than the dollar, find U.S. goods and services attractively priced. Thus, U.S. exports have been experiencing solid gains while imports are sluggish due to a slower U.S. economic recovery and apprehensive U.S. consumers. In the short term, the weaker dollar will help U.S. manufacturers better compete in world markets and provide a needed lift to the U.S. economy. Furthermore, U.S. based multi-national businesses will also benefit when their international operations report foreign earnings in terms of the U.S. dollar. Longer term, however, the weaker dollar can contribute to inflation. Specifically, as the U.S. economy recovers and consumers begin to ramp up their spending levels and resume purchasing higher-priced foreign goods, U.S. manufacturers will have the flexibility to increase the prices of their domestically produced goods leading to a higher level of inflation.
As the U.S. economy struggles to recover from the worst downturn since the Great Depression, there are those who seek to learn valuable lessons from the experiences of the 1930s. One of the major problems in the Great Depression was the desire to protect U.S. manufacturers from foreign competition by levying tariffs on imported goods. This policy was implemented with the Smoot-Hawley tariff act in June, 1930. While well intentioned, it touched off a trade war with massive retaliation by foreign governments on U.S. goods causing international commerce to grind to a halt. This unfortunate policy was followed two years later by large increases in federal and state tax increases. Arthur B. Laffer, chief economic advisor to President Ronald Reagan and the creator of the Laffer Curve (The Curve in brief states that “cutting the tax rate increases economic activity and generates higher tax revenue than the higher tax rate”) fears that those in charge of the economy today will misinterpret the evidence from the Depression and attribute high unemployment and the initial decline in prices to tight money while simultaneously increasing taxes to combat huge budget deficits. Frankly, there are some disturbing signs that these ideas may be in the offing and developments need to be monitored closely for their potentially negative consequences for the economy. (Incidentally, the Federal budget deficit for the fiscal year that ended on September 30 is estimated to be a staggering $1.58 trillion.)
While all these issues will have some effect on economic growth, the actions of the Federal Reserve will be closely watched as they can have an even greater impact on the economy. Just a year ago, the Federal Reserve (the Fed) reacted to the melt-down within the financial sector by providing unprecedented liquidity to the banking and financial systems. Without enumerating all the steps the Fed took, those steps were taken to prevent the total collapse of the worldwide financial system and they were successful in preventing Armageddon. After a year of propping up the system, the Fed is now considering the various steps it needs to take to unwind all the vehicles used to support the system. To date, the Fed has been
pursuing a plan of gradually weaning the system off various support programs. This is a delicate process as the Fed does not want to end any program abruptly. If it moves too fast, the system could collapse again but if it moves too slowly, the excessive stimulus in the system could ignite a serious bout of inflation. One component of this plan is the Federal Funds rate currently hovering between zero and 0.25%, the lowest on record. While the Fed has signaled that it will not hike short term interest rates until it is certain that the economy is on a sustainable expansion, several Fed governors have already signaled that the Fed will very likely raise rates aggressively once the time is right. As always, it remains to be seen how this process is implemented and how the capital markets react to the Fed actions.
While the financial system has shown encouraging signs that it is on the mend and the capital markets appear to be functioning almost normally, there are still lingering problems that need to be resolved before the “all clear” signal can be sounded. The banking system has pulled back from the brink of collapse and has had to write down or write off a huge number of bad residential mortgage loans. This process has necessitated the U.S. Government taking equity positions in several large financial institutions in exchange for providing capital to these institutions. Now, some of the stronger entities that took these government loans are paying back this debt and freeing themselves from strict government oversight and supervision. This has created the illusion that everything is returning to “normal”. Nevertheless, the residential mortgage situation is a work in progress with a few well-regarded institutions suggesting that there will be at least another seven million homes that will be going through foreclosure over the next several years. The write-downs and write-offs associated with these foreclosures will be a continuing drag on bank earnings and the homes will add considerably to the inventory of homes available in the resale market. As large as this problem is, another problem waiting in the wings is commercial mortgage loans. This could very well be the “next shoe to drop” for the banking industry. While overall estimates are difficult to come by, the commercial mortgage loan problem could potentially be as big as the residential mortgage loan crisis. To put this into context, the International Monetary Fund (IMF) recently estimated that the world financial institutions will sustain losses of $3.4 trillion between 2007 and 2010. Of this total, the IMF estimates that $1.5 trillion in losses still need to be written down by the end of 2010. Unfortunately, there is no way to know whether the markets are prepared for this kind of news but, at this point, it is prudent to remain cautious about the financial sector. With this as background, the concerns about faltering commercial mortgage loans may be one of the contributing factors causing banks in the U.S. to continue to tighten lending standards and curtail new loans to credit worthy borrowers.
In contrast to the economic fundamentals, corporate earnings were surprisingly good for the second calendar quarter and generally better than reduced Wall Street estimates. Specifically, for the second quarter, corporate earning fell by about 33%, but 73% of companies reported earnings that were less bad than expected. This relatively good news provided continuing support for the ongoing rally in the equity markets. For third quarter earning about to be reported, Thompson Reuters estimates that S & P 500 earnings will be down 25%, not counting charges and special items. Again, it is expected that a high percentage of companies will surpass expected earnings providing further support for the equity markets. To date, the better than expected earnings (or if you prefer: the less bad earnings) have been the result of drastic cost cutting and severe reductions in payrolls. Cost cutting can only go so far, meaning that future earnings improvement will rely increasingly on sales gains. Should companies begin to show sales gains, profit margins will expand and provide further impetus to the equity rally. At this critical time for the markets and the economy, investors will likely focus their attention on management commentary and guidance which usually accompanies the release of quarterly earnings. At the very least, investors will be looking for reassurances that the currently higher equity prices are justified by an improving outlook. Any evidence to the contrary could be detrimental to further market gains.
At this juncture, the markets have turned in a stellar performance with the DJIA approaching the 10,000 just prior to the end of the quarter. With the DJIA up 46% in the last six months, this advance becomes one of only six of that magnitude within the last 100 years. Interestingly, all previous rallies of this size took place either in the 1930s or in the 1970s according to Ned Davis Research. Significantly, those times were periods of turbulence for the economy and the markets and none of the gains were sustained. Obviously, this begs the question whether this rally in 2009 will break with the past and hold its gains or simply retreat to a more reasonable level. In looking at the fundamentals, there is reason for caution in the outlook for the remainder of the year and into 2010. Among the distinct possibilities is the consumer remaining restrained leading to a second leg down for the economy (in other words a “W” shaped recovery), corporate profits and ultimately, the equity markets. Stocks are certainly not cheap at current levels and appear to have priced in a fairly normal recovery. Having climbed a wall of worry during the last seven months, the markets deserve a healthy breather and October has often provided the excuse for a meaningful market correction. In this case, after the spectacular gains since March 9, it would be wise to hope for the best but be prepared for stormy weather.
This material is for your information and is intended for use with current or prospective clients. The information does not constitute investment advice or a recommendtion to buy or sell any security and is subject to change without notice. Past performance is no guarantee of future results. All material has been obtained from sources believed to be reliable, but the accuracy, completeness and interpretation cannot be guaranteed.
