The stock market rallied strongly in the Second Quarter much to the relief of investors who were weary of nothing but bad economic news.Given the terrible financial position our country has been in, it was great to see portfolios turn positive for the year through June.
Second Quarter 2009:
The S&P 500 was down 25% on March 9th and appeared to be heading lower.Since then stocks have pretty much gone straight up.What changed?We all know how important psychology is when it comes to market sentiment.As we progressed through the second quarter, the fear which had pervaded the stock market for the last nine months started to dissipate.The government’s ability to stabilize the banking system and thus the economy helped reduce these fear levels.The nineteen major banks in the U.S. passed the government’s “stress” test in May.This in turn further boosted investor confidence and many of these banks were able to raise needed capital in the private market to improve their balance sheets.
As we progressed through the spring, there was less bad news.Economic data such as manufacturing and construction spending, pending home sales, unemployment, income levels and consumer confidence were not as bad as expected.While these numbers would have been viewed poorly in a better economic climate, in the current one when everything has been awful, “less bad” is good.Economists looked for the bright side of all this information and concluded that we were nearing the end of the recession.Going out six to nine months, economic forecasts called for a return to moderate growth in the 4th quarter of 2009 or early 2010.
As fear recedes, investors are willing to take on more risk.This in turn translates into shifts away from safer assets such as bonds and money markets and into stocks.Afraid of missing the recovery, hedge funds and mutual fund companies started to pour more money into equities.The stock market rose.
2nd Quarter Adjustments to Portfolios:
We talked last quarter about our belief that, over time, we would be entering a period of increasing inflation, not deflation, as we moved through 2009. This “reflation” trade helped explain the strong comeback in the stock market this past quarter.We believe that “easy” money will eventually lead to a dollar decline versus the other major currencies in the world.Commodities are dollar based and as the price of the dollar goes down, commodity prices will go up.While year-over-year consumer price changes have been negative, commodities continued their torrid increase in the second quarter.Oil shot up to over $70bbl., a doubling of prices in three months.
As these events occurred, we increased exposure to the energy sector.While there has been a recent retreat from its highest levels, oil and related products remain high and this should be a good investment over time.
The other area that has performed very well is the growth area.The NASDAQ, which contains many growth companies (Google, Apple, etc.), was the first index to turn positive in April.Investors have been betting that growth companies will benefit most from an economic recovery and this index continues to do very well.Funds that have these types of growth stocks include the Vanguard Strategy Equity and the Mid-Cap Growth funds.
Most portfolios under management were very liquid as we moved into the 2nd quarter.Having a large amount of cash on hand was a strategy to protect against further downward movements and also give us the opportunity to invest if it appeared that the market was stabilizing.This did in fact prove to be the case, and, as we moved through the quarter, we moved more dollars into equities.
The Second Half of the Year:
Where does the market go from here?There are certainly many varied opinions on this matter, and as you might expect, data to support those positions.On the down side, pessimists point to the quick run-up in the stock market (about 35% from its spring lows) to suggest a pull-back is around the corner.In the great Depression, stocks rallied five times going up 25-45% each time from 1929 to 1932.Unfortunately this did little as the stock market declined a total of 89% during those three years.Those who think the market will fall back claim we are seeing a temporary upturn in a secular bear market (in a secular bear market the longer term trends are always down despite temporary gains).
Optimists, on the other hand, point to momentum and the pent-up buying power that is important in keeping prices high.There is close to $10 trillion dollars in stable, low-yielding investments such as cds and money markets and savings accounts.Investors who have missed this rally will at some point invest billions of dollars into equities which will give positive support to stocks.In addition, from a technical standpoint, stocks have risen above longer term moving averages which is a positive sign.
In the end, the key to a sustained rally remains the strength and durability of the economic recovery itself.This in turn has to translate into increases in corporate earnings.Second quarter reports will show huge declines from the previous year which is expected.“Guidance” from companies (which is their way of steering investor expectations relative to 3rd and 4th corporate profitability) is going to have to be positive enough to continue this rally going.If this profitability does not materialize, the market will stall or go backwards.
We have made a conscious effort to err on the side of caution as it pertains to portfolio investments.Given the catastrophic events of the last nine months, that has seemed to be the prudent thing to do.We have moved dollars into those sectors that seem to have the most potential while still keeping some dollars in reserve to protect if the economy falls off the rails again.The moves we have made have resulted in substantial gains in some of the growth and energy mutual funds. Most portfolios are positive for the year yet still have cash.This strategy has worked out fairly well so far.
Bruce Kraig,July 13, 2009
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