Tuesday, July 6, 2010

"The Second Quarter: Risks Bows to Safety"

Sydney M. Williams

Thought of the Day
“The Second Quarter: Risk Bows to Safety”
July 6, 2010

The trouble with stock market adages is that you can’t count on them. Investing, like life, is not easy – if it were, the game would be no fun. However, a number of records were set during the second quarter which lend credence to the old saying, “sell in May and go away.” I wish I had. The second quarter was the worst quarterly performance since the fourth quarter of 2008; it was the worst second quarter since 2002, and May, according to the Financial Times, was the worst May since 1962.

It was a quarter that could be best characterized as a flight to safety. The DJIA were down 10% versus a 13.1% decline for the broader New York Stock Exchange Index. The German DAX was down 3.3%, while the London FTSE and the CAC 40 in Paris were down 13.4% and 13.3% respectively. Of the major overseas markets, the Shanghai Index put in the worst performance, down 22.9%. U.S. Treasuries rose, with the yield on the Ten-Year declining 23% to 2.95%, while the yield on the Bloomberg-FINRA High Yield Index rose from 8.68% to 8.93%. Gold, silver and natural gas were all higher; nevertheless the CBOT Index was down 8.1%, led by copper, oil and grains. The Dollar Index was up 6.1% for the quarter. As investors fled risk, volatility picked up, with the VIX almost doubling, up 96.4% to 34.54. The number of days in which the market traded up or down more than 1.5% doubled from the first quarter – 12 days versus 6 days.

The stock market’s decline reflected slowing economic growth and the fear of a “double-dip” recession. The Economic Cycle Research Institute (ECRI) reported the growth rate of its leading indicators fell to a thirteen month low. First quarter GDP, at 2.7%, was less than half that of the fourth quarter. Unemployment remains high and the jobs numbers on Friday did not add to confidence. Keep in mind, though, that the slow return of jobs, which was indicative of the previous two recessions, is illustrative of improving technologies, growing productivity, expanding global trade and older workers staying on the job longer. On the positive side, but ignored by the market, the consensus estimate for second quarter earnings, according to Barron’s, is estimated to be up 27%. Additionally, recent ISM data (representing the manufacturing sector of the economy – 12% of GDP), while slowing, is still expanding.

The question investors must address: Has risk become cheap enough? Any answer is only a guess, but with the S&P 500 trading at about 12X consensus estimates and the yield on that same index just under 2% – about 2.6% if one includes only the 371 dividend paying stocks – and with the Ten-Year Treasury under 3%, stocks seem pretty reasonable. The earnings yield on the S&P 500, at nearly 8%, compares very favorably to the 3% yield on the U.S. Ten-Year. However, stocks can look attractive for a long time. Even so, an article in the weekend edition of Barron’s pointed out that 13 of the top 25 companies in the S&P 500 now sell at 10X or lower estimated 2011 earnings. The forward multiple on the Index is at its lowest level since the late 1980s, a time of significantly higher interest rates.

At the same time, Treasuries look expensive. Three percent for ten years only looks reasonable if one is betting on deflation. The richness of Treasuries can be seen in the spread of Investment Grade Corporates over the Ten-Year, which widened during the quarter from 105 basis points to 181 basis points. (Of course, the biggest beneficiary of low Treasury interest rates is the U.S. Government. Should rates tick up 100 basis points that would add $130 billion to the governments operating budget, based on current debt of $13.1 trillion.)

History, like statistics, can be used to prove any premise, but with that as a caveat it may worth looking back at 2002, the last time we had a second quarter as bad as this one – then down 13.7% versus the 11.9% decline in the last quarter. Most of you recall that the market peaked in March 2000 and by the end of June 2002 it had declined 35.2%. (In comparison, today the S&P 500 is 34.6% below its peak in October 2007.) Ten years ago, the Index fell further in the first three weeks of July before a powerful four-week 23% rally into August. The market then fell sharply before bottoming in early October 2002. The biggest differences between then and now are the ten year numbers: In 2002, even with the market down substantially from where it had been two years earlier, the market was still up 142.5% from where it had been ten years earlier. Today the market is up 4% from where it was at the end of June 2002.

In 1959, Art Linkletter wrote a book, Kids Say the Darndest Things; one could certainly say the stock market is capable of the “darndest” moves.

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