Stock markets around the globe stumbled in the second quarter, primarily due to sovereign debt concerns in Europe and signs of slowing economic growth in the U.S. and major emerging markets.  From its April 2 peak to its low point on June 1, the S&P 500 Index fell by 9.9%.  Smaller companies and foreign stocks suffered larger corrections as investors perceived these sectors as having more exposure to a weakening economic environment.  A strong 4.0% advance in June for the S&P 500 helped to cut the quarter’s losses.

International stock markets suffered the greatest damage during the quarter as Europe’s economy continued to stall and interest rates for Spanish and Italian government bonds rose to levels that would make it difficult to finance their national debt.  While still growing, emerging market economies slowed from the rapid pace of the last several years.  In particular, China has been slowing the last 6 months and there is concern that their real estate markets are overvalued.

The table below shows total returns for major stock and bond indices for various time frames.  The dismal performance of developed international markets mainly reflects stagnant economies in Europe and Japan. Demand for Treasuries pushed the yield on the 10-year Treasury bond down to 1.66% at the end of June from 2.22% at the end of March and down from 3.16% one year ago.  The BarCap Aggregate Bond Index, which measures the performance of the taxable bond market, generated 2.1% returns during the quarter.

Total Returns: Major Indexes for Periods Ending on June 30, 2012

During the quarter, equity markets were primarily impacted by news out of Europe.  Investors worried about the ability of several European countries to repay their sovereign debt and that a weak European economy could trigger a U.S. recession.  If this scenario sounds familiar, it is a virtual repeat of the conditions that were present in each of the past two summers.  And there is some strong likelihood that investors will be worrying about these same concerns next summer.  European sovereign debt issues have helped to produce three market corrections in three years.  As various bailout programs are announced, the concerns recede and the markets rally, only to falter again when the problems reappear. The European officials have so far failed to find a comprehensive plan to solve the root causes of the crisis.  Europe is in recession.  Greece is effectively in a depression, and the risk of Spain & Italy becoming overwhelmed by the crisis remains high.  At the end of the day there is no easy or painless solution to Europe’s problems, which will create more volatility moving forward. This situation has caused many equity investors to lose patience, seeing their investments rise and fall with each new headline.

Most of the short-term movement of the stock market is driven by the news of the day.  Investors that adhere to a marketing timing strategy attempt to move in and out of stocks based on the expected outcome of near-term events.  Recent developments demonstrate how difficult it is to predict the future and also that conventional wisdom is often wrong.  Here are some examples:

U.S. Treasuries were downgraded by S&P credit rating services last July from their AAA rating.  Normal expectations would be that interest rates would rise on these securities which are now deemed to be riskier.  However, the interest rate on the 10-year Treasury bond fell by almost 50% since the downgrade.  We believe that the drop in the 10 year treasury rate was mainly driven by the European debt crisis which caused equity market volatility as mentioned above.

Another credit rating agency, Moody’s, announced in February that it was reviewing the credit worthiness of 100 banks around the world.  In June, Moody’s downgraded five of the six largest U.S. banks.  Ironically, the Federal Deposit Insurance Corporation recently reported that the U.S. banking industry earned a $35.3 billion profit in the first quarter of 2012, its best quarter since 2007.  It was the 11^th consecutive quarter that bank profits increased compared to the prior year.  The financial sector was a top performing industry sector in the first half of 2012, with total returns of roughly 11%.  Most likely, the financial sector will have to participate if the stock market continues to rise.

The healthcare care law was upheld by the Supreme Court in a ruling that shocked almost all observers.  Chief Justice John Roberts, voting with the four liberals on the court, upheld the individual mandate as a tax, rather than a penalty – an interpretation that no one expected.  The ruling caused significant movement in a number of stocks, based on how they were perceived to be impacted by the law going forward.

Just a few months ago, experts were predicting $5 per gallon gasoline for this summer as the price of oil approached record levels.  Instead, according to AAA, gasoline is currently selling at a national average of $3.34 per gallon.  This price reduction is primarily due to a global economic slowdown which has lowered demand for oil, and the easing of some political tensions in the Middle East.

These surprises should teach investors it is almost futile to predict short-term events.  As the second half of the year progresses, there is no doubt the market will fret about the outcome of the U.S. presidential election, the fiscal cliff (the expiration of tax cuts & scheduled government spending cuts), and the ongoing problems in Europe.  In addition, we are still facing several headwinds including high unemployment, the debt ceiling issue, and a still unhealthy housing market.  Stocks are likely to exhibit a high level of short-term volatility, due to the many uncertainties and because, more so than in most periods, economic prosperity is dependent on the actions of government officials.

With so many negative headlines, it is often possible to lose sight of the long-term positives for equity investments.  However, stocks have excellent long-term return potential when considering that company valuations are very attractive (low price/earnings ratios and high dividend yields), corporate earnings are rising (albeit at lower levels), inflation is low, interest rates are low, corporate and family balance sheets have improved significantly, housing and auto sectors are recovering, and the banking crisis has passed.  In addition, alternative investments, such as money market funds and bonds appear to offer unattractive long-term returns.

Sometimes we are asked “Should we sell and move to cash?”  As mentioned above, selling and moving to cash is not a prudent strategy.  When do you move to cash?  When do you move back to equities?  Market timing is nearly impossible, and very few people get it right consistently.  Furthermore, let’s not lose sight of the fact that we should and do have a long-term focus when managing our investment portfolios.  Because we are invested for the long-term we need to have patience.  Unfortunately moving forward the markets will be volatile due to all the issues the U.S. and the global markets are facing.  When it comes to long-term investing success, patience is a virtue.

We continue to recommend that investors diversify across all major asset classes [equities, bonds, short-term, real estate & commodities].  In addition, based on periodic investment analysis, make adjustments to the portfolios as necessary.  The current investment markets are complex and challenging.  This is a true “advisor” environment.

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

— Kirk Weiss & Tom Franks