The stock market continued its rally into the third quarter as improving economic conditions allayed fears about the recession and the financial crisis, which had taken center stage for much of the past year. Stocks were positive in all three summer months.
Last quarter, we talked about the quick run-up in the stock market through the end of June. At that point in time, stocks had rallied about 25% from the low that were hit on March 9, 2009. Well, since then the market has continued to sprint straight up, gaining 15% in the third quarter. The S&P 500 and the DOW now stand about 50% above those same lows in the spring. We believe that many analysts and Wall Street watchers have been surprised and caught off guard by this most recent surge.
Most of these individuals expected a retracement of the gains and a testing of the lows experienced in March. While fundamentals have improved, most of the improvement occurred through cost reductions and not through increases in sales or revenue. This did repair much of the damage done to corporate balance sheets but unemployment remained high. The feeling was that the recession was still in play and consumer demand was going to remain anemic. In cases such as this, stocks generally stall.
In fact, the market went down about 7% between the end of June and mid-July. This was a time of anxiety and waiting to see how 2nd quarter earnings were going to turn out. Well, in the end, earning came out stronger than expected. These good earnings reports gave renewed impetus to the equity market, and when stocks did not fall back, large hedge funds and mutual funds plowed back into the market to make up for lost ground. The resulting "demand" kept the rally going.
Third Quarter Adjustments to Portfolios:
Our goal in the third quarter was to continue to move more dollars into the small-cap and mid-cap growth areas. When there is a rebound in the economy, smaller (and mid-cap) companies often have the ability to react more quickly to those economic changes. Investors become increasingly aware of the possibility of such a rebound and then will often bid up the prices of small-cap shares. This happened in the third quarter as the Russell 2000 continued to outpace the S&P 500 Index and is now up about 23% for 2009.
The areas that have performed the best in 2009 are generally the growth sectors. Defensive stocks such as large pharmaceuticals and other steady performers such as Coca-Cola and McDonaldís have lagged slightly. Many of our portfolios have a core holding in the Vanguard HealthCare Fund which historically has done very well. This year, however, health care is up about 11% versus the S&Pís return of 19%. Although health care is usually considered defensive, the current uncertainty about the resolution of the health care legislation is hampering performance. We continue to consider the Vanguard HealthCare Fund a valuable holding while shifting to more nimble funds (and companies) will allow for excellent returns going forward.
The Rest of 2009:
We thought it would be instructive to share with you some historical data about what has happened in situations similar to the current one over the last 80 years. While every economic rebound is different, more knowledge is always better than less in planning for the future.
Going back to the Great Depression reveals that there have been five other rallies of the magnitude of the current one. Some have been as short as two months, while others have lasted substantially longer: the one in late 1974 running for almost two years. A very important point is that in most cases, the majority of the gains occurred in the first six months. There were gains after this first six month period, but the "easy" money was made in that shorter time frame.
In addition, four of these five rallies were during the period of the 1930ís. The market would go up explosively but then drop back down again. For example, the market rose over 90% in two months in 1932, but lost almost 40% shortly after. The gain of 48% in 1929-30 was followed by the drop of 89% we talked about last quarter. In fact, the stock market took 50 years to get back to the levels it had reached prior to the Depression. Only the great bull market from 1982-2000 saw a sustained rally which eventually ended with the dot.com collapse which we most certainly remember.
So what are the lessons, if any, that we can learn here? Well, one lesson is to perhaps apply some caution going forward. Given the cataclysmic declines we endured from last September through mid-March of this year, it would be wise to keep in mind where we have been. Some believe that there is still room for the market to go up. However, if history shows that most gains occur in the early stages of a rebound, it is important to remember that fact.
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