Don’s Outlook 7/2/2010
Although the stock market staged a rebound early in June and recovered some of the lost ground inflicted by May’s relentless slide, stocks rolled over last week and resumed their decline to close out a dismal quarter. After this week’s decline, the S&P 500 Index has made a new low for the year, crossing below its 200-day moving average. Although the market has seen its share of volatility in 2010, a comparison of the average returns over the past 10 years indicates that the market is often seasonally weak during the summer months before staging a rally later in the year. So in spite of structural headwinds and the risk of softer economic data ahead, monetary policy remains accommodative to growth and corporate profits are still on the rise.
Additionally, the drumbeat of negative news has subsided somewhat in recent weeks, giving investors a psychological reprieve from the barrage of geopolitical uncertainty. Nevertheless, investors are once again faced with the reality that big government is here to stay. Before the Group of 20 (G-20) nations met over the weekend to pronounce their desire to rein in deficit spending—before it becomes part of the problem rather than the solution—Congress announced reconciliation of sweeping financial regulations, the prospect of which has loomed heavily over markets for months. Although the impact and scope of the bill were less draconian than originally feared—it appears as though the $19 billion levy to pay for its implementation will be dropped in favor of less onerous fees—the attempts to impose trading limitations on hedge funds and restrictions on proprietary trading among banks are real.
Although last week’s home sales data was disappointing and the final revision to first-quarter 2010 GDP was revised down to a gain of 2.7 percent, durable goods orders rose again, which reaffirms the belief that capital spending is on an upswing. This week’s all-important employment report showed improvement. Once again, we need to look past the hiring of temporary Census workers to see that private payrolls gained ground since May and the unemployment rate dropped to 9.5 percent, its lowest level in almost a year.
With Treasury yields tumbling toward their previous extreme levels, it is tempting to load up on bonds. While I still believe in a healthy exposure to fixed income securities, I do not expect that this run-up in bond prices will reach the extremes of 2008. There is now a great disparity in the long-term valuation of Treasuries and the S&P 500, the former garnering a premium over stocks not seen for more than 50 years. For example, while the trailing 10-year return for stocks is once again negative, it is far below its long-term average of a positive 11 percent since 1945. Bonds, however, are returning close to their long-term average of 6 percent, so there is bound to be a reversion to the mean in the not-too-distant future. The question is what level of valuation in stocks is needed to turn the tide once and for all, and end this outperformance by bonds.
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