Fall 2011 Market Review

Given the volatility in the capital markets over the past few weeks, it is easy to forget that the market was just a hair from its 52-week high as recently as July. Then, a flurry of events has made the once happy days of spring feel like a distant memory. With the debt ceiling debate going into the eleventh hour, Standard and Poors announcing a debt downgrade, and the euro-zone debt crisis seemingly reaching a crescendo, confidence has been severely impacted and concerns over the durability of our recovery have been raised.

At the end of April, the S&P 500 was up 9.1% for the year. But in the following four months, the market has declined by -9.9%. Most of this decline occurred in just 10 trading days surrounding the conclusion of the debt debate. What has followed in the past month has been a see-saw, back and forth battle between the bulls and the bears, which has yet to subside.

For the year-to-date through August 31st, the S&P 500 is down -1.8%. With the still unresolved euro-zone crisis, international markets have had an even tougher time as the MSCI EAFE is down -6.0%. There remains a significant “flight to safety” trade, however, and the bond market has rallied significantly in recent months returning 5.9% on a year-to-date basis.

Economic growth began to weaken in the spring due to manufacturing disruptions caused by the disaster in Japan and an extremely harsh winter in the northeast. A rapid rise in gasoline prices following widespread political upheaval in the Middle East added pressure to consumers and caused economic growth to slow even further. More recently, the chaotic conclusion of the debt ceiling debate, the subsequent downgrade of U.S. debt, and the ongoing crisis in Europe have added to investor pessimism and sparked extreme volatility in the capital markets.

With this recent convergence of events, significant concerns have emerged that economic growth will continue to decelerate and that another recession could occur. A recent report showed that GDP grew at the discouraging pace of 1.0% in the second quarter. In the wake of all of the recent market volatility, growth is likely to be weak in the 3rd quarter as well.

Along with the slowdown in economic activity, there has also been a notable decline in job growth. The recent August employment report revealed that zero jobs were added for the month. For the first four months of the year, jobs were added at an average pace of 179,000 per month. For the last four months, the pace has declined to 40,000 per month. President Obama has taken note and recently proposed a $450 billion stimulus package intended specifically to encourage hiring.

A clear bright spot in our economy has been the rapid improvement in corporate profits. Companies continue to post better than expected gains in profits driven largely by increases in efficiency and profit margins. Earnings are expected to exceed peak levels this year with no slowdown in sight. Companies have also built massive stockpiles of cash, which can protect them in the event of an economic downturn and fuel hiring and investment activities once confidence returns.

Earlier in the year, commodity prices posted steep increases. This stirred fears that inflation was becoming a serious problem. However, as economic concerns have increased, the speculative interest in commodities has rapidly declined. Since their highs in April, commodities prices have declined significantly, with the exception of precious metals. As measured by the S&P GSCI, commodities are down -11.4% since the end of April and have posted a year-to-date return of 3.2%. Gold has returned 28.3% so far this year, with most of those gains coming in just the past few months. Overall, inflation concerns have quieted considerably as confidence in the economy has eroded.

With the end of the Federal Reserve’s Quantitative Easing program and the subsequent (but unrelated) credit downgrade of U.S. debt, many assumed that interest rates for U.S. Treasury bonds would head higher. That assumption proved incorrect as interest rates moved rapidly lower. U.S. Treasury securities have again asserted themselves as the primary safe haven asset for investors looking to avoid risk. Recently, benchmark 10-year Treasury bond yields were as low as 1.9%, which matched a multi-generational low. However, interest rates for most other types of bonds have risen.

While we do not expect a repeat of the dramatic market slide that began in the fall of 2008, it is impossible to deny that the mood among investors has darkened. The rancorous debate surrounding the debt ceiling, the subsequent downgrade of U.S. debt by Standard and Poors, and the ongoing crisis in Europe have all played a role in contributing to the dour mood in the capital markets. However, stocks appear to be attractively priced, corporate results are very strong, and U.S. banks are much better prepared to deal with financial uncertainties than they were in 2008. We continue to believe that patient investors, with portfolios properly situated for the long-term, are well positioned to benefit from an eventual return of confidence in the economy and the capital markets.

Thank you very much for your continued confidence in our service and advice. If you would like to discuss our opinions, outlook, or your portfolio in greater detail, we would be happy to schedule a meeting or a conference call at your convenience.

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