Concerns over slowing economic growth across the globe produced a significant correction for virtually all major stock markets in the third quarter.  The S&P 500 Index lost 13.9% during the third quarter and has lost 17.1% from its 2011 high which occurred on April 29.  It was the worst third quarter performance for the S&P 500 since 1928, according to Bespoke Investment Group. Foreign stocks, as represented by the MSCI EAFE International Index, had a bigger third quarter loss of 19.6%.

Total Return Performance of Major Indexes for Periods Ending on September 30, 2011

 

The chart of the S&P 500 below shows that the recovery that began in 2009 has had some setbacks, and the recent quarter was one of the most significant.

While the global economy was struggling going into the third quarter, the inability to favorably resolve budget and debt problems in both Europe and the U.S. has seemed to erode consumer, business, and investor confidence.  The Greek debt crisis remains in the news on a daily basis, currently without a solution.  The failure of the U.S. Congress to address short and long-term budget issues in July, compounded by a rating downgrade of US debt by Standard & Poors were the major contributors to the U.S. market’s steep decline.  The problems in reaching an agreement for raising the debt ceiling highlighted the ineffectiveness of Congress in dealing with important economic issues.  More so than in most time periods, the global economy is currently dependent on politicians and bureaucrats to act forcefully and intelligently.  Policy decisions currently in the hands of government officials will have a significant impact on the global economy over the next year.

The steep market correction also reflects that many investors now believe that the U.S. has either entered another recession, or will shortly enter one.  There is an old Wall Street adage which says that the market has predicted 9 of the last 5 recessions.  In a number of instances, the market has declined in anticipation of a recession; however, many of those recessions never materialized.  For example, in the summer of 2010 the market suffered a 15.9% decline on fears of a double-dip recession, which never occurred.  The economy continued to expand and the market recovered strongly.  The stock market also suffered major corrections in 1998 and 2002 due to fears of recessions which never happened.  Investors are now more skittish after the major market decline in 2008-2009, and head for the exits if they sense a possible, significant downturn.

Unfortunately, the gains from the bottom of last year’s market correction have largely evaporated as recession fears are again unnerving investors.  This pattern of short-term volatility combined with poor long-term returns has lead many investors to believe that market-timing is a viable strategy for generating returns – or at least avoiding losses.  However, this strategy is fraught with danger, since predicting the events which cause market movements is virtually impossible.

A study by Dalbar for the 20 year period ending 2009 concluded that retail investors trail the market returns by 5% per year, mainly due to selling when prices start to drop, and buying when they rise, i.e., trying to time the market.

Even some institutional investors try market timing and come up short.  Locally, The Pittsburgh Business Times August 2011 issue documented the City of Pittsburgh Pension board’s failed attempt to time the market.  In August 2010, when the market was down and fears of a recession loomed, the board unanimously voted to sell all of its stock holdings on the advice of its investment consultants. At the time, the plan was invested 60% in stocks and 40% in bonds. After selling all of its equities last summer, the plan continued to hold no stocks until March 1, 2011.  By then the market had recovered significantly and recessionary fears had faded.  Between March 1 and March 31, 2011, the plan reestablished a 60% exposure to stocks.  Of course, as is now apparent, the market timing strategy resulted in selling low and buying high.  The Pittsburgh Business Times estimates that the strategy cost the pension plan up to $35 million, compared to having remained at a 60% stock/40% bond mix through the entire period.

Much of the selling that occurs during a market correction is based on emotion.  After seeing a decline in market values, some investors become fearful that further losses will occur.  This fear, and in some instances panic, will result in selling without any regard to the underlying value of the investments.  For long-term investors who focus on the value of companies, there is no reason to sell undervalued positions, and if cash is available, a market correction usually presents an opportunity to buy.  For example, renowned investor, Warren Buffett, commented to Bloomberg news that he had purchased $4 billion of equities during the third quarter as the lower market presented better values.

During market corrections, it takes a stronger resolve on the part of long-term investors to stick with an investment strategy.  With the decline in market value, long-term performance is eroded and investors lose confidence in equities as a long-term investment vehicle.  However, despite the negative news, there are a number of reasons for owning equities:

• Stocks appear to be undervalued compared to their long-term earnings potential, dividends, and other valuation metrics.  For example, the S&P 500 is trading at just 11.0 times forward earnings, significantly below its historical average.

 

• Earnings for U.S. companies are at record levels.  While the S&P 500 Index trades at approximately the same level it was 10 years ago, earnings for the index have increased from $38.85 in 2001 to an estimated $98.02 for 2011.

 

• Cash on corporate balance sheets is at record levels; balance sheets are in great shape.  Treasury Strategies, a consulting firm, reported that corporate cash now stands at $2.05 trillion, 4.5% higher than the previous quarter, and 46% higher than in March 2009.

 

• Stocks now generate more income than bonds.  The dividend yield of the S&P 500 is currently 2.39%.  The yield of the Barclays Capital U.S. Aggregate Bond Index is 2.35%.  The yield on the 10-year Treasury bond is 1.71%.

 

• Expectations for stocks and the economy have declined significantly in recent months.  If a recession does not develop, stocks are likely to rally, as they did is the fourth quarter of 2010.

 

• Politicians are likely to take actions that will boost stock prices.  We are currently in the third year of the presidential cycle.  The third year is by far the best performing year of the four-year presidential cycle, probably due to actions intended to stimulate the economy and markets prior to the presidential election in the fourth year.  There has not been a negative third year since 1939.  Since 1930, the S&P 500 Index has average 18.4% in the third year of the presidential cycle.

 

Economic conditions are weak in Europe and the U.S. and another recession is possible.  Consumer demand is soft because individuals are saving rather than borrowing and spending.  Banks are no longer lending to unqualified borrowers.  Unemployment is high in many areas due to layoffs in the bloated public sector.  Long-term funding and spending issues regarding entitlement programs are finally being addressed.  The road to a stronger economy and higher stock prices is likely to be unpredictable with many ups and downs.

However, there are many constructive factors in place which should eventually lead to a positive outcome for patient, long-term oriented investors.  (As of this writing, the S&P is up about 6% since the start of October, which is a positive sign that a market recovery is possibly underway.)

Please contact us if you have any questions about the financial markets or your accounts.  If current market volatility is uncomfortable for you, you may want to consider a more conservative investment objective.  This will reduce your long-term expected return, but may be the most appropriate action given your risk tolerance and future goals.  We have developed a new questionnaire to help you make this decision.

 

–Tom Franks & Kirk Weiss

 

Total Return Performance of Major Indexes for Periods Ending on June 30, 2011

 

The market was essentially flat during the recent quarter.  However, that result belies a lot of volatility, and forces impacting the market including the European debt crisis, the US debt problem, slowing GDP growth, and weak US job growth.  The S&P 500 reached a post-crash high on April 29, but then fell by 7.3% to its low point for the quarter 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 averse investors poured $46 billion into bond mutual funds during the quarter, despite interest rates offering historically low yields.

A more positive perspective can be seen from the S&P 500 return of 30.7% during the past year.  Even though the last year contained many negative events, (e.g. Gulf Oil Spill, the May 6 “Flash Crash”,  and the first Greek bailout)  the market continued its strong recovery.

However, there are increasing headwinds in the current economy.  The pace of the US economic recovery is slow.  In the first quarter, GDP grew at just 1.9% (compared to 9.5% for China).  Unemployment remains stubbornly high at 9.2%.  The housing market is still bouncing along the bottom.  The Federal Reserve’s second monetary stimulus program (QE2) of 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 Italy, Spain and Ireland. 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.

The pessimists argue that the recent data points to a declining economy, and a possible “double dip” recession.  However, the Federal Reserve, and many prominent economists believe the current economic slowdown is a “soft patch” or only a temporary slowdown due to a jump in oil prices, the Japanese tsunami and nuclear plant disasters, and  some bad spring weather, e.g., floods and tornadoes.  We are now  more cautious but are not in the “double dip” camp.

Despite these challenges, US companies are actually doing well in the current environment.  The combined earnings of S&P 500 companies are expected to reach record levels in 2011, increasing by approximately 15% over 2010.  Valuations for US companies appear to be reasonable, with the S&P 500 trading at 13.3 times estimated earnings.  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.

However, as a result of the higher level of risk of a market downturn, we have taken some steps to reduce risk in more aggressive portfolios.   We have sold off leveraged ETFs in most portfolios, increased holdings of funds and stocks that pay a significant dividend, taken gains in company stocks in economically-sensitive areas (e.g., materials & industrials), and added some growth stocks which should do well due to innovative businesses, even in a slowing economy.

Fixed income investments outperformed stocks in the second quarter, as interest rates declined. The BarCap Aggregate Bond Index, which measures the performance of the US taxable bond market, generated 2.3% returns during the quarter.  The yield on the benchmark 10-year Treasury bond declined from 3.5% to 3.2% 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 remain somewhat risky (since bond prices decline when interest rates rise).

The news affecting the markets is an ever-changing drama that bounces to and fro between optimism, skepticism, and pessimism.  Interpreting these global signals is both art and science, but at a minimum, emphasize the importance of keen analysis.  Our frequent advice is to set the course for long-term goals, and let us worry about the daily news.  History has shown than those who do not panic when times are uncertain are more successful in the end.  Be assured that we do our best to navigate our clients’ portfolios through this sometimes turbulent environment.

Please contact us if you have any questions about the financial markets or your accounts.

 

–Tom Franks & Kirk Weiss

Let’s say you possessed a crystal ball which could foretell significant world events months before they happened. At the beginning of the year, the crystal ball predicted there would be major political uprisings in North Africa and the Middle East as well as the ouster of long-time dictators. It foretold a civil war in Libya, a halt to all Libyan oil exports, and the US entering the war on the side of the rebels. It forecasted a 17% spike in the price of oil, a sharp decline in the US dollar, a major 9.0 earthquake and tsunami devastating Japan, and a nuclear and environmental disaster.

If an investor knew of these extraordinary events months before they occurred, it is likely that he or she would have been inclined to sell their equity holdings. The stock market typically does not react well to negative news. However, in the face of major unsettling events, the stock market, as measured by the S&P 500 Index, had its best first quarter since 1998, producing returns of 5.9%.

Total Return Performance of Major Indexes for Periods Ending on March 31, 2011

 

As can be seen in the preceding table, with recent performance, the S&P 500 now displays positive returns for the current quarter, 1, 3, 5 and 10-year periods. It is the first quarter-end since September 30, 2007 that shows positive returns for all time frames. While the 3, 5, and 10-year returns are below the long-term average for stocks of almost 10%, moving into positive territory will go a long way toward restoring investor confidence in equities. Many investors who had moved money into low-returning fixed income securities as a safe haven over the last several years are now more comfortable investing in stocks.

To explain how the market rose in the face of all of the pessimistic news is almost as difficult as trying to predict the stock market’s next move.

The strong stock market performance is related to a recovering US economy, monetary stimulus by the Federal Reserve, a weakened US dollar which spurs US exports, improving job market and consumer confidence, rising corporate earnings, and strong global demand. Fortunately, the many, diverse factors supporting the stock market give it strength to avoid being derailed by recent negative events.

The last quarter taught us once again, it is virtually impossible to predict future events and their impact on the stock market

While the market has moved beyond the fears of a double-dip recession that spooked it in the middle of 2010, most of last year’s nagging problems still exist. Several European countries struggle with massive debt problems, the US faces large budget deficits at the federal, state and local levels, and the housing industry shows almost no signs of recovery.

Fixed income investments produced modest returns in the first quarter as interest rates inched higher. The BarCap Aggregate Bond Index, which measures the performance of the taxable bond market, generated 0.4% return during the quarter. The yield on the benchmark 10-year Treasury bond rose from 3.30% to 3.45% during the quarter. Most observers believe that the Federal Reserve’s purchase of Treasury securities as part of its current quantitative easing program has resulted in maintaining a low interest rate environment (as the Fed intended). There is some concern that interest rates will begin to rise when this program ends in June. Rising interest rates generally result in lower prices for fixed income securities.

The events of the last three years have been difficult for many Americans. Almost everyone suffered in some way – the loss of a job, the loss of value in their home and investment accounts, and the general anxiety caused by a global financial crisis. While prosperity has not returned for everyone, most recognize that the current trend is showing steady improvement. Although significant problems need to be resolved, further progress should contribute to positive results for investors.

Please contact us if you have any questions about the financial markets or your accounts.

–Tom Franks & Kirk Weiss