Turnaround or Bounce? Look To The Banks

Last week’s positive move in the stock market was overdue, but it is unclear whether this is the beginning of a turnaround or merely a bounce from oversold conditions. There is some evidence that market conditions are improving. Last week’s rally was broad-based and volume was heavy, which are strong technical factors. Additionally, lower-quality stocks have been outperforming, which typically happens as markets turn around. However, it is very possible that we are still bottoming-out.

There was good economic news last week. Retail sales figures were surprisingly positive. January’s data was revised to show that sales actually rose, and February’s numbers were down only slightly. All told, it appears possible that overall first-quarter retail sales growth will net out to around zero, a much better scenario than was widely anticipated only a few weeks ago.

Today more good news. An unexpected rise in housing starts and a more moderate increase in wholesale prices point toward a brighter economic outlook. Another plus, the market appears to have leveled off before the recently passed stimulus package has started to have any effect.

That said, the overall economic environment remains troubled, and as Federal Reserve Chairman Ben Bernanke said last week, “Until we stabilize the financial system, a sustainable economic recovery will remain out of reach. In particular, the continued viability of systemically important financial institutions is vital to this effort.” The banking system needs to stabilize before we see a full recovery.

Second Quarter Market Review

"You make most of your money during a bear market; you just don’t realize it at the time." Shelby Cullom Davis

The first half of the year had all the thrills and chills of a bad horror flick. There were nauseating triple digit declines in the U.S. market, warnings of collapse among players in the global financial system and the subprime-mortgage-housing foreclosure crisis debacle. Then we had a rally in early spring and investors breathed a sigh of relief as many believed that the subprime monster had been tamed and the worst was behind us.

Ah, but never underestimate a bad horror movie. There was more than just one monster in this picture. The oil monster was on the rise and he scared consumers out of their SUVs. His pal, the inflation monster, also caused fear as he caused food prices and healthcare costs to rise. In response, the markets ran scared and fell hard again. These last two monsters, oil prices and inflation, delivered a one-two psychological blow to the markets. Investors had been lulled into feeling safe by the early spring rally that had pushed the market averages into positive territory for the year. Of course, everyone knows that you can never be safe until the hero, Obama or McCain, captures the monsters and saves the economy. But I am getting ahead of myself; let’s first talk about the second quarter.

So a sharply negative first quarter was followed by two months of positive returns, but the selloff resumed with a vengeance in June, with large-cap stocks dropping over 8%, resulting in a 3% decline for the second quarter. Surprisingly, Mid Caps and Small Caps hung on to have a positive quarter with the S&P400 Mid Caps rising 8.7% and the S&P 600 Small Caps up 3.5%.

Value stocks fell across the board, which is not surprising since the financial, mortgage and housing stocks are all in bad shape. Conversely, Growth stocks were positive across all market caps. Domestic high-quality bonds were down just over 1% for the second quarter and up just 1% for the year. Though not a good return in a normal environment, bonds did provide balanced investors with a modicum of protection from stock-market losses, which is part of their role.

Being diversified outside of U.S. stock market didn’t help much. Developed international markets fell 2.3% for the quarter and are down almost 11% year-to-date. Emerging markets were positive for the quarter earning 2.2% but are still down almost 10% for the year.

Interestingly, international bonds have performed well this year. They are one of the least risky ways to profit from the declining dollar. Emerging market debt has performed admirably, reflecting the rise in third world countries on the economic world stage. PIMCO Developing Local Markets was up 3.3% over the quarter and 5.8% year-to-date. PIMCO Foreign Unhedged that invests in developed countries was down 5% for the quarter but still up 5% for the year.

The only relief domestically was in the commodities markets which have profited from rising food, metal and oil prices. Unfortunately, commodities look like a speculative bubble that is going to pop.

Last Week in Review

The U.S. stock market fell sharply last week. The market consistently fell during the week with only positive trading day mid week. The bulk of the decline occurred on Friday due to new unemployment data for May and another dramatic rise in oil prices.
For the week the S&P 500 declined 2.8% and is down 6.5% year-to-date. Mid and Small Cap stocks held up better than the Large Caps last week and for the year. A trend not predicted by most market prognosticators, including myself.

Last Friday’s unemployment report showed greater weakness in the labor market than expected in May. The drop was significant, with payrolls declined by 49,000 and unemployment surged to 5.5%. Some economists postulate that this spike in unemployment may be a one-month aberration; however the labor market clearly has been weakening in 2008.

The negative side of the economic story is clear, with headlines focusing on housing and higher commodity prices. The primary main story rolling forward is going to be inflation, and its impact on consumers, interest rates and the markets. Inflation and tightening credit have restrained consumption in recent months and are likely to remain headwinds for some time to come.

It is Time to Rebalance

At the end of last week, the indices were all moving towards new highs. Despite slowing earnings growth the market just keeps heading up. While the long term trend is healthy, I think we are in for some turbulence. Usually when the market moves aggressively ahead, pushing toward new highs, after a while it takes very little news to derail the train. It seems inevitable as we head into the summer that the market will consolidate its gains by pulling back a little. The market will then take the summer off to digest the latest gains.

While the majority of the economic news remains positive there are negatives looming out there. For instance, there is slower U.S. employment growth, tightening credit, higher gas prices, slowing corporate earnings growth, and falling housing prices). Despite the negatives, the current situation does not warrant selling and walking away. Corporate earnings are still strong and P/E ratios are still reasonable (see chart). The current market conditions do warrant implementing a strategy of rebalancing and trimming. Increasing cash holdings over the next few weeks will enable an investor to take advantage of any pull backs. The catalyst(s) that could spark a correction is (are) unknown, but it could finally be the U.S. consumer cutting back or disappointing economic data.

It is likely that turbulence will be minor should it happen at all. The new global economy will continue to perform well pulling the U.S. market along with it. The story here is really the global economy and not just us anymore.
For right now, the market is still hot because of accelerating merger-and-acquisition activity. As of the end of last week the mid cap market has been blazing hot since the start of the year. In the last few weeks large cap domestic stocks have picked up the pace. It is very unclear whether large caps will finally outperform small and mid caps this year. It is inevitable that large caps will at some point outperform its small cap brethren in the future due to valuation metrics (see past blog postings for more information). International stocks are still chugging along with the MSCI EAFE up approximately 8% for the year. Bonds are showing some life with the Lehman Bros Aggregate index up almost 2% year-to-date.

Investment Performance Commentary for November

Money and Investing - Performance Results November

Surprisingly, November was another good month for all the asset classes. The large-cap S&P 500 gained almost 2%, while smaller-cap stocks, as measured by the Russell 2000, gained 2.6%. Based on Russell indexes, value edged out growth in both the large- and small-cap areas. I was surprised by the strong performance this month of small caps. As I have explained in my previous newsletters (which can be found on my website http://www.altamontwealth.com the strong out performance of small cap stocks cannot be maintained indefinitely based on current valuation. Mid-caps were the anomaly this month: their 3.6% gain was significantly ahead of both large- and small-caps, and growth beat value by 70 basis points (that’s 0.7%). I frequently find that Mid Cap stocks don’t perform as expected because most of the investment world does not recognize them as a separate asset class.

The foreign stock Vanguard Total International benchmark was helped by a declining dollar, and posted a 3.7% gain in November. On the bond side, the Lehman Aggregate Bond Index was up 1.2%; high-yield corporates gained 1.6%, and developed markets foreign bonds climbed by 2.8%. Among our tactical asset class weightings, commodities gained 5.5% and emerging local markets bonds were up 2.2% (both positions are funded from an underweight to bonds). REITs gained another 4.7%, bringing their year-to-date tally to a dizzying 37.6%. I do not recommend owning REITs because they are over valued compared to the market value of the real estate they hold. They are still being valued primarily on the high current dividend rate.