Review of the Third Quarter 2010

To the surprise of many investors, global stock markets rallied powerfully during the 3rd quarter, and in the process offset the losses incurred in the first half of the year. The Standard & Poor’s 500 Index advanced 10.7% and the Dow Jones Industrials rose 10.4%. Even more impressive were the gains of 20.0% in the EEM Emerging Markets ETF (which includes China, India, and Brazil among others) and 18.1% in the EFA Developed Countries ETF (which includes Europe, Japan, and Australia among others, but excludes the U.S.). Most bond holders also enjoyed positive returns, as did investors in gold and many other commodities. Losses in the quarter were sustained by investors who were short these markets and currency traders who bet on further gains in the U.S. dollar and/or wagered against the euro.

At the beginning of the quarter, a pervasive gloom and doom had settled over the U.S. and international financial markets. The U.S. economy had hit a “soft patch,” and some highly publicized forecasters warned of a coming double-dip recession. Europe was racked with sovereign debt headaches that threatened another credit crisis and battered Euro Area financial markets. The leading emerging markets (China, India, and Brazil) grappled with inflation fears, which provoked some pundits to predict that initiatives taken by the governments and central banks to slow their overheating economies might overshoot and plunge their countries into recession. As risk aversion spread, the S&P 500 Index corrected -16% from April 23 through July 2, and some key international markets suffered even greater declines. By early July, an overwhelming majority of technical analysts in the U.S. and abroad predicted more losses to come.

The expected decline never occurred. Global stock markets rallied in July, when strong quarterly corporate profit reports once again exceeded estimates. A further batch of disappointing U.S. economic data in August, however, rekindled pessimism and reduced the advance. As September loomed, investors braced for more dismal economic news and were reminded by the financial media that September is historically the worst performing month for the U.S. stock market. One indication of the growing pessimism was that $16.53 billion flowed out of U.S. stock mutual funds in August, which came on top of a $10.45 billion net withdrawal in July (Investment Company Institute). Inflows into bond funds soared despite historically low yields. Bearish investors were emboldened: by the end of August, the New York Stock Exchange short interest (shares sold in expectation of profiting from future price declines) hit a 52 week high.

The September “stealth rally” was triggered by a surprisingly solid U.S. employment report released on September 3 and then supported by economic news that further discredited forecasts of a double-dip recession. An increase in corporate merger and acquisition activity was also encouraging. Adding to the optimism were favorable developments in Washington. Action in Congress to provide incentives for small business owners to hire workers and talk of an extension of the Bush tax cuts boosted the markets. The Federal Reserve also contributed by announcing its readiness to provide additional monetary stimulus in November. As the rally gathered steam with further gains each week, the pressure intensified on short sellers to limit their losses by buying into the market. The September rally was historic: the 8.8% jump in the S&P 500 Index marked the best performance of this often-dismal month since 1939.

The threat of a double dip recession combined with continued accommodation from the Federal Reserve to lower the yield (and raise the price) of bonds. The yield on the benchmark 10-year U.S. Treasury note fell to a near-record 2.51%, thereby continuing a decline dating back to April 5, when the yield peaked at 3.99%. This drop in yields took place even as the U.S. Treasury auctioned off a record $2.3 trillion of notes and bonds in the fiscal year ended September 30. Many companies took advantage of this opportunity to sell bonds at rock-bottom interest rates, and corporate debt was eagerly purchased by yield-hungry investors confronted with money-market funds yielding 0%. Most commodity investors prospered during the quarter. The CRB commodity price Index jumped 11% during the quarter, with spectacular surges in wheat (+30.4%), corn (+37.5%) and sugar (+48.6%). With much fanfare, gold topped $1300/oz. and closed September at $1307/oz. Notably lagging were energy prices: oil rose only 9% and natural gas fell -16.6%.

Currency fluctuations were surprising and significant. The U.S. dollar, which had risen 13.8% against a basket of currencies between January 1 and June 7, retreated 6.8% in the 3rd quarter. To the dismay of travelers planning trips to Europe, the euro ballooned 14.0% against the U.S. dollar following a 32.1% plunge from last November 25 through June 7. The continuing ascent of the Japanese yen, which rose a further 6.6% against the dollar, created consternation within the Japanese government and among investors in Japanese stocks. The government reacted by selling yen in the market in hopes of supporting exports and bolstering the slumping Japanese economy. Investors were disturbed: the meager 1.9% rise in the Tokyo Nikkei 225 stock market index during the quarter amounted to a miserable underperformance. Perhaps most noteworthy in the currency markets is what did not happen: the Chinese yuan inched up 1.3% against the dollar when many governments, especially the U.S., were demanding and expecting a sharp appreciation.

Review of the Second Quarter 2010

As the quarter opened, optimism regarding the global economic recovery helped propel equity and commodity markets to post recession highs. The International Monetary Fund (IMF), for example, raised its forecast for 2010 global GDP growth from 3.8% to 4.2% and reiterated its prediction of 4.3% in 2011 (see our April 23 blog “Global Growth Accelerating”). Other elements of the positive case for stocks, including strong corporate earnings reports, very low inflation and interest rates, and assurances from the Federal Reserve that they would continue their accommodative policy for an extended period, also fueled the rally. For the Standard & Poor’s 500 Index, the high water mark was reached on April 23, at which point this benchmark had soared 79.9% since the beginning of the rally on March 9, 2009.

For the remainder of the quarter, global financial markets were buffeted by relentless negative headline news emanating mostly from Europe and the U.S. The major focus was on the debt problems of Greece, Portugal, Spain and several other Euro Area countries, which generated fears of sovereign defaults, a Euro Area banking crisis, and a retreat into recession as governments turned to austerity programs to redress their budgetary woes. Nightly reports of the rampaging BP oil spill in the Gulf of Mexico and scenes of suffering wildlife and crippled local businesses contributed to the gloomy mood. Another headache was the heightened tension between South and North Korea, which raised the specter of a military conflict that might involve nuclear weapons. The final blow was a disappointing U.S. employment report in early June which, coupled with discouraging housing and other economic data as the quarter drew to a close, pointed to at least a slowdown (and maybe something worse) in the U.S. economy.

The aggressive, speculative, and unregulated pursuit of short-term profit by U.S. and international hedge funds exacerbated the severity of the May and June decline in equity and commodity markets. Armed with powerful computers programmed to react almost instantaneously, often with leverage, to the latest news release or to shifting price and volume patterns in financial markets, the hedge funds’ high-frequency trading strategies created unnerving market volatility (see our May 24 blog “Global Financial Market Turmoil”). On one memorable early May afternoon, runaway computers unleashed, in 15 minutes of spellbinding shock, a 700 point intraday plunge in the Dow Jones Industrial Average, whereupon the market recovered the entire 700 points in the next hour. The jump in market volatility in May and June heightened investor anxiety, which then seemed to feed upon itself. As the financial media, in heated competition for ratings, fanned speculation of a double-dip recession and a new bear market, pessimism became fashionable. By the end of June, the long-term positive case for stocks, which had dominated markets in April and was still arguably relevant, was completely eclipsed.

Another consequence of the computer-driven, hedge-fund trading during the quarter was the inter-connectedness of global equity, commodity, bond, and currency markets. An event in one country could quickly cause a chain reaction around the world. For example, each new indication of debt problems in Greece or Spain triggered a jump in these countries’ bond yields and declines in the euro and European stock markets, which led to an immediate rise in the U.S. dollar and U.S. Treasury prices and a plunge in U.S. stock prices, which prompted a decline in commodity prices and a selloff of stocks in the leading emerging economies of China, India, and Brazil. U.S. investors were forced to recognize that global economies and financial markets had become so intertwined that seemingly obscure events in far off places could profoundly impact U.S. stock and bond prices.

The Standard & Poor’s 500 Index slumped -11.9% for the quarter, and the EFA Developed Countries ETF, which consists primarily of Europe and Japan, plummeted -16.9%. The EEM Emerging Economies ETF declined -11.4% despite booming economic growth and healthy financial institutions in China, India, and Brazil. Also on the losing side was the CRB Index of commodity prices, which fell -5.4% paced by a -8.1% slump in oil prices. A notable winner was the U.S. dollar, which traded inversely to the U.S. stock market and rose 6.1% against a basketful of currencies. A flight to safety by risk-averse investors was especially beneficial to the perceived safe havens of gold and U.S. Treasury notes and bonds. Gold tracked the rise of the U.S. dollar (and decoupled from other commodities) as its price soared from $1115/ounce to $1244/ounce. The yield on the benchmark 10-year U.S. Treasury note dove from 3.83% to 2.94%, while its European safe-haven counterpart, the 10-year German government bond, fell to 2.59%.

Within the S&P 500 Index, 7 of the 10 industry sectors, representing 88% of the Index, posted declines ranging from -10.1% to -14.5%, and all 10 sectors had negative returns. The largest setbacks were in the economy-sensitive energy (-14.5%), consumer discretion (-14.0%), and materials (-13.2%), whereas the least impacted were the recession-resistant sectors of telecommunications (-0.5%), utilities (-5.3%), and consumer staple (-6.2%). Many individual stocks suffered plunges: 97 stocks were off 20% or more, and 24 of these stocks plummeted 30% or more. Size did not offer safety: the 23 largest companies (those with market capitalizations in excess of $100 billion), recorded an average loss of -12.3%. Apart from the S&P 500 Index, the Dow Jones Industrials were down -10.0%, the Russell 2000 Index of small company stocks shed -10.2%, and the NASDAQ Composite (mostly technology stocks) retreated -12.0%. Of the 24 international country ETFs we monitor closely, 19 were down more than -10.0%, 4 of the leading emerging economies (China, Hong Kong, India, and Singapore) fell single digits, and 1 (Chile) managed a 3.2% gain. There were few places to hide in either the U.S. or international stock markets.

Review of the First Quarter 2010

Global stock markets in the U.S. and abroad weathered a temporary setback in January and early February and then rallied to extend beyond one year the new bull market. In its best 1st quarter since 1999, the Standard and Poor’s 500 Index rose 4.9%. This marked the 4th consecutive positive quarter without a correction in excess of 10% and increased to 72.9% the advance dating back to March 9 of last year. Despite fears of inflation and central bank tightening in China, India, and Brazil, the ishares Emerging Markets ETF (EEM) rose 1.5%, which increased its advance from last March to 111.0%. Although Europe was plagued with sluggish growth and a sovereign debt crisis, the ishares Developed Countries ETF (EFA) was up 1.3% for an overall gain of 76.6%.

The catalysts for the early quarter’s correction, which amounted to declines of -8.1% for the S&P 500 Index, -12.9% for the EFA, and -14.7% for the EEM, originated in China and Greece. In January, the Chinese government, concerned that strong economic growth would accelerate rising prices for real estate and food, introduced curbs on excessive bank lending. Alarmist speculation from some China watchers that the Chinese policy makers were about to prick a bubble economy triggered profit taking. The inflation contagion spread quickly to the Indian and Brazilian markets, where fears mounted that interest rate hikes by their central banks might choke economic growth. The storm passed quickly and all three markets recovered, but inflation clouds were still visible on the horizon as the quarter came to a close.

If the problem in China, India, and Brazil was that their economies were too healthy, the problem in Greece, Portugal, and Spain was that their economies were too sick. Many of the Euro area governments resorted to huge budget deficits to fight the recession, but national debts measured as a per cent of GDP were most worrisome in these countries. Although there was widespread agreement that a Greek default was unacceptable, the crisis was exacerbated by fierce worker resistance to belt tightening measures proposed by the Greek government and ugly bickering among Euro area governments as to who would finance a solution to the problem. As European stock markets trembled and the euro dropped like a stone, government leaders, the European Central Bank (ECB), and the International Monetary Fund (IMF) finally worked out a compromise. By the end of March, European stock markets recovered and the euro stabilized, but the potential for debt headaches down the road persisted.

Despite high unemployment, anemic consumer spending, a weak housing market, humongous federal deficit projections, and unseemly, vicious partisan squabbling in Congress, U.S. stock investors focused on positive developments. Driving optimism in the U.S. stock market upward were fresh data showing economic recovery, strong and above-expectation 4th quarter corporate profit reports, and comforting statements by the Federal Reserve that inflation was under control and an accommodative policy would be maintained for “an extended period.” An indication of investors’ confidence was that the best performing S&P 500 industry sector was consumer discretion (+11.8%) followed by industrials (+9.3%). On the bottom rungs of the ladder were the relatively conservative telecommunications (-2.5%) and utilities (-2.9%). In their optimism, investors preferred low-quality stocks, and their appetite for many of the big blue-chip stocks was meager: suffering declines were Exxon Mobil (-1.8%), Microsoft (-3.9%), AT&T (-7.8%), Pfizer (-5.7%) and Coca-Cola (-3.5%).

An interesting and noteworthy development in the 1st quarter was that the gain in the U.S. stock market was accompanied by a rise in the dollar. Since early 2008, the dollar and stock prices had exhibited a pronounced inverse relationship, and for both to move up together was seen by many investors as a positive sign that recession fears had subsided. Commodity prices usually fall when the dollar rises, and the CRB Commodity Index declined 3.5% during the quarter. On the other hand, gold gained $15.50/ounce to $1115.50/ounce and oil rose from $79.36/barrel to $83.76/barrel.

The bond market was relatively calm during the quarter: the yield on the benchmark 10-year U.S. Treasury note started the quarter at 3.84%, never rose above 3.88% nor fell below 3.56%, and ended the quarter at 3.83%. Thirsty for yield, individual investors continued to pour money into investment-grade and high-yield bond mutual funds despite the huge borrowing needs of the government and expectations that the Federal Reserve will push interest rates higher later in the year. As a result, the spread between U.S. Treasury notes and corporate bonds narrowed to levels not seen since late 2007. An ominous development in March was that both investment-grade and high-yield “junk” corporate bond issuers increased significantly their issuance of new bonds, thereby indicating their view that yields will most likely rise (and prices fall) in the future.

Review of the Fourth Quarter and Year 2009

Amid further evidence of global economic recovery, many of the trends dominating financial markets since early March were extended through the 4th quarter. The U.S. and international stock markets rose, including gains of 5.5% in the Standard & Poor’s 500 Index, 6.7% in the EEM Emerging Markets ETF, and 1.1% in the EFA Developed Countries ETF. Most commodity prices continued their ascent, including a hike from $70.61/barrel to $79.36/barrel in the price of oil and a pop from $996/ounce to $1,100/ounce in the price of gold. The yield rose (and price fell) on the benchmark 10-year U.S. Treasury note and the interest rate on most money-market funds remained at or below 1.0%. A notable new development was a December rally in the dollar against major currencies, which may be attributed to surprisingly positive U.S. economic data suggesting that the recovery might be accelerating. An immediate consequence of the dollar’s bounce was to reverse partially the upward surge in commodity prices, and in particular gold, and to reduce the relative attractiveness of international investments.

Despite an early year plunge in global equity markets, 2009 will be long remembered for the dramatic and unprecedented bull market that commenced in early March and continued without a significant correction for the remainder of the year. For the S&P 500 Index, this rally measured 64.8% and, in the process, the Index offset its -25.1% decline earlier in the year and left a satisfying 23.5% gain for 2009 as a whole. Many investors failed to match the performance of this standard benchmark, and some investors participated minimally or not at all. The Investment Company Institute’s (ICI) reports to the Federal Reserve show that for 2009 through November there was a net outflow of $4.127 billion from stock mutual funds and that as of December 29 there was still $3.293 trillion tucked away in low-yielding money market funds. According to Hedge Fund Research, the average hedge fund returned 19% to investors in 2009. Morningstar’s data on mutual fund performance also indicates that few fund managers shifted strategy in early 2009, with the result that many of the best performers in 2008 were among the worst performers in 2009, and vice versa.

Some of the keys to successful equity investing in 2009 were:

• The old Wall Street adage don’t fight the Fed was especially relevant in 2009. Governments and central banks around the world initiated massive and unprecedented stimulus packages in late 2008 and early 2009, yet stock markets in January and February suffered a cascade of selling culminating in a brutal capitulation in early March. Investors who ignored the pervasive gloom and doom and exercised patience in waiting for the beneficial impact of the stimulus policies were rewarded.

• It’s always darkest before the dawn. We cannot remember a time when it was more pitch black than in early March, when the S&P 500 Index was off 58% from its October 2007 high. Nevertheless, in late March a consensus of economists predicted an economic recovery in late 2009 and 2010 (see our April 1 Outlook). Some investors understood that the stock market is an anticipatory mechanism, which historically has bottomed about 6 months prior to the end of past recessions, and increased their commitment to equities in the 2nd quarter. They were richly rewarded.

• In our view, equity strategies based on a 6-12 month horizon are more often correct and easier to execute successfully than short-term, market-timing strategies. From late March through the end of the year the financial media hosted a parade of gurus who incessantly questioned the sustainability of the rally and promoted the view that a sharp correction was inevitable and immanent. On the other hand, we pointed out in our October 1 Outlook that successful market timing requires not one but two correct decisions, and that it is especially difficult to execute in the midst of an upward moving market supported by economic fundamentals. There never was a correction greater than 7% in the S&P 500 Index, and many market-timer investors either bought back their shares at higher prices or ended up sitting on the sidelines as the bull market rolled on.

• In a bull market, be bullish. There was a widespread belief in the early stages of the rally that a majority of investors, shocked and damaged by the devastating bear market, would favor defensive blue chip stocks in any market rally. To the contrary. Historical evidence is that following recessions and bear markets, those equity investors still active in the markets are driven by bargain opportunities and/or the promise of cyclically driven growth. This was true in 2009. The top-performing industry sectors in the S&P 500 Index were the economy sensitive materials (+43.3%), consumer discretion (+38.3%), information technology (+35.5%), and energy (+27.4%). On the lower end of the ladder were the defensive sectors of consumer staples (+13.8%), health care (+13.1%), utilities (+6.4%), and telecommunications (+2.4%). The big and presumably safer Dow Industrials (+18.8%) lagged.

• Investors need to be willing to take a global perspective. By the 2nd quarter it was already evident that the leading emerging economies (China, India, and Brazil) were weathering the global recession far better than the leading developed countries (U.S., Europe, and Japan) and also would provide stronger and more assured growth in an eventual global economic recovery. It was thereby reasonable, and correct, to expect these emerging economy stock markets to outperform significantly the developed country markets (see our April 1 Outlook). In 2009 the EEM Emerging Markets ETF soared 66.2%, whereas the EFA Developed Countries ETF rose 23.2%.

In the 2009 bond market, it was a good year for corporate bonds, and especially low-rated “junk” bonds, but a miserable year for investors in U.S. Treasury securities. Going into 2009, when the recession storms were howling, fears of a multiyear deflation were widespread, and the global credit crisis threatened almost all leading financial institutions, money flowed into super safe U.S. Government securities. The resulting decline in yields was also a consequence of unprecedented measures taken by the Federal Reserve to stabilize economic and credit conditions. As of the last trading day of 2008, 90-day Treasury bills yielded a paltry 8 basis points, 2-year Treasury notes yielded 77 basis points, and the benchmark 10-year Treasury note yielded a near record low 2.21%. We pointed out in our January 6, 2009 Outlook that the yields on shorter term bills and notes were too low to have investment appeal, and the yields on longer maturity Treasury securities would likely rise (and prices fall) when the recovery we anticipated later in 2009 set in; we recommended high quality, intermediate-term corporate bonds. As it turned out, U.S. Treasury securities suffered their worst total return year since 1978, as indicated by the 3.84% yield on the 10-year note at the end of 2009. In contrast, yields declined (and prices rose) for most corporate bonds as economic recovery improved corporate credit and diminished concerns for maximum safety.

Among the major beneficiaries of global economic recovery in 2009 were commodity prices, which also surged in response to a massive decline in the dollar from early March to the end of November. For the year as a whole, the commodity price index (CRB) jumped 23.5%, which included a 77.9% pop in the price of oil (from $44.6/barrel to $79.36/barrel) and a 26.5% rise in gold (from $869.7/ounce to $1100.0/ounce).

Review of the Third Quarter 2009

In defiance of the laws of investment gravity, equity markets around the world soared during the 3rd quarter. The Standard & Poor’s 500 Index, for example, surged 15.0% without a setback greater than -4.4%. Including the gains dating back to its nadir on March 9, the S&P 500 rally measured a whopping 53.6%; the largest correction was a modest -6.7% between June 9 and July 10. The Dow Jones Industrial Average, also up 15.0%, enjoyed its best quarter since 1998 and its best 3rd quarter since 1939. The geographical breadth of the rally is evidenced by the even larger advances in the international markets. The EFA Developed Markets ETF galloped 19.4% in the quarter, which increased its advance to 72.5% from its March low; the EEM Emerging Market ETF shot up 20.7% in the last quarter and posted an incredible 95.1% rocket ride from its March low.

There is no confusion as to the catalysts behind the global stock rallies: oversold equity markets in the 1st quarter, positive economic data pointing to recovery from recession, and corporate earnings reports exceeding expectations propelled the markets. Along the way, investors were willing to overcome worries that U.S. consumers remain hobbled by debt, high unemployment, and depressed home prices. As optimism displaced despair and capitulation, the economy-sensitive cyclical stocks, which had been battered in 2008 and early 2009, commenced their Lazarus ascent. Within the S&P 500, the best performing sectors during the 3rd quarter were the financials (+25.4%), the industrials (+21.3%) and the materials (commodity related) stocks (+20.9%). Bringing up the rear were the defensive health care stocks (+8.9%), the utilities (+5.0%), and the telecommunication stocks (+3.9). Indeed, the rush to get in on bargains extended to many of the speculative stocks of small, highly-cyclical, domestic-economy-dependent companies in severely depressed industries. For many low-quality stocks, the rule was: the greater their decline prior to March, the greater their gain since March. So much for the suggestion made by some commentators at the height of the recession that it would be years before risk appetite would return to the stock market.

The same economic factors were at work in the international markets, only here investors were confronted by the reality rather than the prediction of rising GDP. Indications that recovery, albeit modest, had arrived in the 2nd quarter for some of the European countries was a surprising development, which provided in the 3rd quarter a boost to their previously lagging stock markets sufficient for them to keep up with the further advance in the emerging economy markets. For the period since March, however, it was the emerging markets, where growth is the strongest and most assured, which have provided the biggest rewards (see our October 1 Outlook). Within international markets, the industry-sector leaders were the financials, the materials, the information-technology stocks, and the industrials. The health care and utility sectors trailed significantly.

There were some similar patterns in the U.S. and international bond markets, where ravenous risk appetite reigned supreme. The favorable economic data and rosy forecasts encouraged investors to plunge into the low-rated (junk) corporate bond market, which in late 2008 and early 2009 had been frozen amid the worst credit market crisis in decades. The riskiest debt posted the biggest gains. According to Merrill Lynch data, the junk bond market as a whole gained 15% in the 3rd quarter, thereby recouping some of the losses sustained when recession storms had been most intense. U.S. Treasury notes, which are viewed as a safe haven in the midst of economic hurricanes, were less appealing once the sun came out, and gains here were limited. The yield of the benchmark 10-year U.S. Treasury notes declined modestly from 3.54% on June 30 to 3.31% on September 30 as yield spreads narrowed considerably. Treasury note and bond holders were at least comforted with a positive total return, which had not been the case in the 1st quarter. In the international arena, emerging world bonds were the standout performers.

On the commodity front, most prices rose further in the 3rd quarter. The CRB commodity index continued to climb from its March low and rose 3.8% during the quarter. In part the advance reflected a decline in the dollar, which extended its steady descent dating back to early March. Another factor was the growing demand for commodities in the emerging markets, especially China, which drove up the prices of most raw materials. Improved economic prospects for the developed countries also contributed to forecasts for rising future demand. Nevertheless, the price of crude oil, which had jumped 20.2% in the 2nd quarter, fluctuated within a relatively narrow range and the September 30 price of $70.61 was less than $1 above its June 30 close. On the other hand, the price of gold, which frequently moves inversely to the dollar, jumped from $934/ounce on June 30 to above the psychologically key $1000/ounce barrier in September before settling back to $996 as the quarter closed.