Transitioning Hope into Reality

2Q 2009

When we last wrote in this space, we referenced the market’s improved ability to digest economic data, and a willingness on the part of investors to wade further into the risk pool. Credit markets had stabilized materially from crisis levels and equity benchmarks worldwide were approaching official bull market territory. With the S&P 500 posting a total return of 15.9%, its best quarterly performance since 1998, it’s clear to see that the positive momentum in equities continued to build. In some ways, it was like a global sigh of relief, acknowledging that we are evidently not falling into the abyss.

Perhaps even more encouraging than the absolute performance, however, was the diversified nature of returns witnessed between various asset classes. Despite its strength, the S&P 500 actually trailed Emerging Markets by nearly 20%, with the other distinct segments of the equities market appearing somewhere in the middle. Within the Fixed Income arena, High Yield bonds rose 23.1% while safe-haven Treasuries dropped another 3.1%. These divergent returns highlight the benefit of diversification and disciplined rebalancing over time.

Of course, returns waned somewhat in the later part of June. It was about this time when the pundits really began to come forth with the term “junk rally”. This argument has been approached primarily from two angles. Some point specifically to those stocks that have appreciated the most over the last few months. According to Bloomberg, the money losing firms within the MSCI World Index, those that had posted negative earnings per share over the last year, outpaced the index as a whole by an 18% margin. Tops among these were the financial service firms that had been decimated in crisis, only to charge higher as government stress test results were better-than-expected and the ability to raise modest amounts of private capital returned. The other angle quite simply suggests that the massive Spring-time rally was built on hope, or expectations for economic stability that has yet to materialize. The idea here is that stocks cannot move meaningfully higher without actual good news, and that “less bad” is no longer going to get the job done.

Surely we could pick-and-choose a handful of technical indicators to suggest recovery is already underway: increased commodity prices, reduced market volatility, higher long-term Treasury yields, banks repaying the Federal Reserve, and even a modest bounce in exports and manufacturing. However, as stock prices are intended to reflect the discounted value of future profits, it will ultimately take a recovery in corporate earnings to drive a sustained rally. According to Thomson- Reuters, the S&P 500 trades at 15.7x its projected 2009 operating earnings per share. This is not a level that suggests stocks are overly cheap, and it’s an estimate that includes substantial growth in the back half of this year. With cost containment efforts fully deployed (think 9.5% unemployment, weekly earnings up only 0.9% year-over-year, and delayed business spending); revenue growth is the primary force able to drive bottom line results. In this environment, confidence among consumers and business leaders will be paramount.

Differing opinions are what makes a market, and the timeline or even magnitude of recovery can certainly be debated. That said, we believe in the eventual transitioning of hope into reality. What’s more, we continue to believe in the basic principles being employed within our client portfolios.