Dion Money Management Blog   Money Management for Retirees and Their Families

I don’t think you can argue that investors have lost sight of the forest for the trees or, in this case, the macro for the micro. The stock market continues to sway with each and every new data point that offers another clue to the ever-unfolding macroeconomic picture—whether it’s employment and manufacturing results or potential changes to interest rate policy. The microeconomic clues, such as corporate profits, are increasingly discounted as history rather than as a confirmation of an ongoing trend.

Once again this week, the balance of the macro data exhibited a softening trend. Durable goods orders grew in July but much less than expected. Although orders for transportation equipment and aircraft surged 13.1 percent and 33.8 percent, respectively, machinery orders declined 15 percent. Overall capital expenditures declined for the month but remain up 10.6 percent year over year.

The disappointing housing data was enough to send summer investors packing, extending the market’s losses for August. Sales of both existing and new homes declined in July. New home sales have been even more volatile than usual, which reflects the expiration of the homebuyer tax credits. Brighter news came from the mortgage applications purchase index, which rose 0.7 percent week over week, giving credence to the hope that the volatility due to the tax credits may be ending.

The market’s summer swoon is coinciding with the tail end of an earnings season wherein more than 70 percent of the S&P 500 companies have beat earnings estimates. Moreover, balance sheets remain robust, and corporate M&A activity is continuing to heat up, with another $178 billion in global deals announced in August, bringing the 2010 global total to $1.3 trillion. Rather than attempting to wring the last bit of margin from the bottom line, healthy firms may look to deploy their capital and buy additional growth rather than “earn” it organically. After having cut costs to the bone, some companies need to hire or expand externally in order to grow.

The bond market seems to be “looking” at the bigger picture as well, reacting more to slumping economic data than the long list of companies righting themselves in the midst of a deep recession. As investors bid the price of bonds higher, the 10-year Treasury note fell to a 17-month low of 2.43 percent, and the yield on the two-year is at record lows around 0.375 percent. The long-term bonds are at their weakest levels since March and April of 2009, when stocks were just beginning to find support. Yet, perhaps the key question to answer is whether the newly depressed yields are the result of dim economic prospects or the Federal Reserve’s affirmation to renew quantitative easing whenever necessary. The next few months of economic results will most likely be pivotal to stock and bond directions, until any further weakness is priced in or the economy begins gaining ground again.

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The balance of data this week showed some additional slowing in manufacturing, but the index of leading economic indicators was higher in July after having declined slightly in June. Both the New York Fed and Philadelphia Fed manufacturing surveys exhibited deceleration after solid three-month trends. This is in contrast to the national ISM survey, which continues to support an upward growth trend.

The latest employment data also took the wind out of the market’s sails this week, when the Department of Labor announced that new jobless claims rose to 500,000, continuing a three-week trend of slightly higher claims. Although no special factors were cited in the release, the extension of unemployment benefits and military service discharges, if miscounted, may have played some part in the uptick.

With 93% of the S&P 500 market capitalization reporting their second quarter results, three out of four companies have beaten the consensus estimates. Information technology and consumer discretionary sectors had the most upward revisions for 2010, while these two sectors were also among the top performers based on year-ago comparisons. Overall, profit trends have been quite healthy, and the outlook remains upbeat, provided the world economy can keep growing. It is important to look at the global picture since profits are increasingly global in scope.

Another quarter of strong earnings translates into improving corporate balance sheets, which has also resulted in a record issuance of corporate debt securities. Healthy balance sheets should allow default rates to decline further, so yield-hungry investors are gravitating toward investment- and non-investment-grade bonds alike as a result. The impetus is corporations wanting to take advantage of record-low rates, and investors have been eager to lend them funds, knowing that economic data is sluggish but corporate balance sheets remain solid. Many of our clients are benefiting from corporate bonds via Federated Strategic Income A (STIAX), which has returned nearly 18 percent over the past year through August 19 and is trading at multiyear highs. Please remember that you do not pay commissions for these A-share funds because they are waived for clients trading on the institutional mutual fund platforms.

Other income-searching investors continue to gravitate toward dividend-paying stocks, which are holding up better than the broader market year to date. Federated Strategic Value Dividend A (SVAAX) is one way that I recommend investing in dividend payers; it is one of our largest holdings for clients. The fund allocates more than 20 percent of its portfolio to consumer staples stocks, which are among the most attractive, yielding 3.1 percent. In addition, SVAAX is now a four-star fund, according to Morningstar’s rankings, and continues to outperform its category over one-, three-, and five-year time periods. The fund has returned more than 14 percent over the past year through August 19.

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Last week’s seesaw market action turned into an outright slide this week as stocks remain stuck in this summer’s range, trading only slightly higher than May’s low but well above the lows of June and July. The excessive pessimism that forced stocks from their April highs has receded, however, as better-than-expected earnings and mixed economic data has analysts and investors assessing the prospects for future growth. In spite of solid valuations, macroeconomic uncertainty was one reason for limiting stocks to range-bound trading.

Investors received some insight to U.S. macroeconomic policy this week when the Federal Reserve met to discuss its own economic outlook and determine the appropriate policy mix moving forward. In the end, the Fed’s action matched the consensus view that it would leave its benchmark interest rate unchanged, but the FOMC did announce that it was prepared to reinvest maturing holdings of Agency and Agency mortgage-backed securities of 2- to 10-year bonds. Although it did not commit to this program or outline a time frame, the announcement opens the door to reverse the process of shrinking the Fed’s balance sheet, which would have caused a gradual tightening of policy. This provides a means to keep mortgage rates low, thereby supporting housing and the economy.

Other key data this week included a higher sentiment reading and a potential inflection point for inflation. The University of Michigan consumer sentiment index rose to 69.6 in August from 67.8 during the prior month, showing gains in the expectations component. Meanwhile, the consumer price index (CPI) rose in July, reflecting a swing in energy prices. Some of the factors that have led to a decline in CPI over the past two months have probably abated. Food, for example, is likely to rise in coming months as the price of wheat continues to escalate from a drought in Russia. Finally, the trade deficit in June widened sharply due to higher import levels. This, along with other weaker data such as construction and inventories, may lead to a revised gross domestic product number for the second quarter.

So, in spite of the fact that stocks look rather cheap at a P/E of approximately 12 compared to their long-term average multiple of 14, a disconnect remains in the eyes of many investors due to changing perceptions. As long as economic data is softening, investors are likely to discount the current earnings season because they are skeptical about future earnings. Moreover, in spite of robust results—with a large percentage of companies beating expectations—analysts are reluctant to extrapolate into successive quarters, even though guidance remained healthy. This has occurred in the past two quarters by the way, possibly setting the stage for another solid earnings picture for the third quarter and higher valuations.

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The stock market seesawed this week, showing that it could rally past the July highs but that it was still vulnerable to incoming data and seasonal weakness. August is traditionally a choppy month that has yielded a net gain on average over the past 25 years. Investors tend to grapple with the strength of a summer rebound and the volatility that typically ensues in the fall months before seasonal strength returns by November. Each year is different, of course, and right now we must balance attractive valuations and solid earnings with elevated macroeconomic risks.

After last week’s reading of second-quarter gross domestic product (GDP) showed that growth moderated to a 2.4 percent annualized rate, this week’s Institute for Supply Management (ISM) data held some promise that the soft patch could end sooner than expected. According to the ISM non-manufacturing results, new orders and employment increased allowing for the composite index to reach 54.3 from 53.8 in July.

Today’s unemployment data was underwhelming due to a mix of seasonal factors and a large decline in temporary government jobs, yet private payrolls did manage to grow by 71,000, and the unemployment rate held steady at 9.5 percent due to a decline in participation rather than robust job gains. There was a silver lining for the employed as both hours worked and aggregate payroll earnings increased.

So the question that most analysts and investors must answer is whether the moderation of growth in GDP will merely represent a soft patch—a normal stage in the recovery cycle—or a precursor to a recessionary dip. After all, every recession since 1950 has shown some degree of moderation after initial growth spurts that were typically brought on by fiscal or monetary stimulus. Although the duration of these setbacks averaged 10 months, the range has been anywhere from four months to 18 months.

As both the monetary and fiscal stimulus measures that were implemented in 2008 and early 2009, respectively, begin to fade, private domestic demand must pick up the slack and carry the recovery forward. Given that manufacturing gains have been somewhat subdued and corporations are cautiously moving forward, there is reason to believe that any economic downturn would be less than the average duration of prior recessionary setbacks. Discretionary spending is at low levels historically, providing ample room to surprise to the upside once employment and income levels rise further.

Although our policymakers and mixed economic data have set a mixed tone for the market, corporations are doing their part to turn the tide of this recovery. During the Federal Reserve’s semiannual testimony to Congress, Chairman Ben Bernanke painted the picture of an unusually uncertain economic environment, and his comments were followed up this week with a subdued Beige Book, which showed the potential for an economic slowdown even though manufacturers were expanding. Meanwhile, the initial second quarter reading of gross domestic product also showed a slight slowdown, declining 0.3 percent to a 2.4 percent annual rate.

While weak U.S. economic data points over the past two months have forced many economists to revise their 2010 growth projections, few were willing to cut their 2011 numbers as quickly, preferring to characterize recent results as a soft patch rather than foreshadowing a double-dip recession. Corporations are doing their part to post strong results and continue to show signs of recovery. The second quarter earnings season has been largely positive, with many sectors beating analysts’ estimates and aggregate earnings rising for the S&P 500. Industrials and technology have been among the strongest sectors and have provided the best guidance for the current quarter.

Many bearish investors have looked to the U.S. bond market for both a refuge from the correction, as well as confirmation that the economy is headed for a recession. Although the softer economic data and uncertainty over future policy were enough to fuel bond prices higher, the economy is far from static. In fact, private demand has been clearly stimulated via fiscal and monetary policy initiatives, but now the U.S. economic recovery must move from a government led affair to one that is driven by consumer spending and business investment. The fact that bonds have performed so well has likely more to do with an accommodating Federal Reserve, low inflation, and modest capital demands to date. Once any of these reverse, we are likely to see progressively higher interest rates.

Although swings in investor sentiment are unavoidable, I remain positive considering valuation levels, global earnings, and macroeconomic data. The European stress tests from last week were largely benign, China appears to be backing off its monetary tightening stance, and investors’ appetite for risk looks set to return once we break free from the recent trading range.

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Earnings season is off to a strong start this quarter, but the results so far have failed to keep the stock market from stalling. Although the majority of companies are expected to post positive results and beat analysts’ expectations, investors are watching revenue numbers closely because they want to see positive guidance for upcoming quarters. So even if business leaders remain confident—the Conference Board CEO Confidence Index remains positive with a reading of 62—not all CEOs are putting their money where their mouths are and upgrading their outlooks, nor are they quick to hire new employees. This split most likely reflects the severity of the recession and anxiety over such unknowns as pending regulatory changes and this week’s European bank stress tests.

One of the weakest segments has been small business sentiment. A separate survey, the NFIB Small Business Optimism Index, fell to 89 in June from 92.2, reversing two month’s of gains. The survey reflects the reality of small businesses continuing to bear the brunt of the recession and being affected more than other enterprises by enduring aspects of the credit crunch. Small businesses create the bulk of new jobs, yet hiring expectations of small businesses have declined the most since October 2008.

Overall, the details from companies reporting thus far have been decent. During the first week of earnings, 47 companies had reported and 72 percent were better than expected. Among the positive results were bellwethers such as Alcoa (AA), Intel (INTC) and CSX (CSX), but only Intel was rewarded for beating analysts’ expectations, reflecting investors’ thirst for positive guidance. This week, after 25 percent of firms had reported results, the technology sector looks the strongest; 16 firms have beaten consensus estimates by 2.9 percent. These are the firms that have been guiding higher over the past two months, and this is one of the top sectors for actually improving its year-end guidance. Other sectors providing broad upward guidance include consumer discretionary and industrials.

However, it would appear that investors are reluctant to rely on the rear-view mirror, so to speak, and the progress made to date. Rather than focus on Q2 results, investors are focused on the road ahead or, in this case, the profit outlook for the second half of 2010 and the guidance for 2011. So far, guidance has been declining for the first time in several quarters. Yet with the economy still expected to grow 2.5 percent in 2010, the severity of this soft patch remains the key question.

Although leading economic indicators have peaked in the short term and economists have reduced their expectations for 2010 output—softer retail sales, slower inventory growth, and a larger trade deficit are part of the reason for the economic downgrade—there is little evidence that we are headed for another recession. In fact, industrial surveys performed by UBS Research Department, a leader in proprietary company research, show end-markets in various stages of recovery. Businesses tied to industrial activity and inventory restocking have shown the most improvement, while late-cycle industries such as aerospace or gas pipelines that rely on capital investment have been slow to turn around. More important, these surveys have shown improvements in credit and financing for manufacturers and suppliers.

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Over the past two weeks, I have discussed the growing divergence in valuations between stocks and bonds, even when viewed from a historical perspective. The fact that bearish sentiment had moved to extreme levels and the percentage of stocks below their 50-day moving averages had returned to the levels of early 2009 were other signs that a reversal was in order.

So it did not take much in the way of positive news to lift the gloom and doom from the stock market. Slightly better employment numbers and still healthy non-manufacturing readings from the Institute for Supply Management (ISM) data seemed to be enough to spark a multi-day rally that continued this week and reversed most of the losses from June, but it was not enough to break the downward trendlines that have developed on the charts.

There has been much technical chatter about a potential head-and-shoulders top formation and a recent “death cross” from the 50- and 200-day moving averages, which occurs when the former crosses beneath the other, preferably when both are declining. However, whenever such signals are widely quoted in the press, they are often discounted by the market as a whole. There were similar calls for a head-and-shoulders top formation to usher in a new bear market one year ago, yet stocks in aggregate proceeded to climb another 38 percent, proving that technical analysis needs to be balanced with a healthy dose of fundamental consideration.

Right now, the fundamentals have shown evidence of slowing but not turning down for good. Although global manufacturing PMI slipped in June, it remains squarely above its long-term average of 51.6 since 1998. And at 55, the monthly reading still sits in expansionary territory and is supportive of healthy growth in U.S. gross domestic product. This week, the release of the Federal Open Market Committee (FOMC) meeting minutes provided some insight to the disappointing data that stalled the market between the April and June meetings. While committee members’ economic outlook softened somewhat, they remained cautiously optimistic. Given that inflation trends have fallen to decade-low levels, some even cited the risk of deflation and the potential for another round of policy stimulus should conditions warrant it.

Another earnings season got underway this week, and so far the results have been positive. Although analysts expect that the first quarter probably represented a peak in earnings growth, the second quarter could still grow by 30 percent. The number of companies who beat expectations and provide higher forward guidance, however, could be lower.

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Investors have clearly become more sensitive to the possibility that economic growth can slow and that earnings growth over the next 12 months could be less than projected. However, few economists at this point are willing to refute that a global economic recovery is still underway and that many corporations remain in strong financial health with solid balance sheets. Yet it took the market reaching deeply oversold levels before investors swooped in to buy up even the most beaten down stocks and sectors this week. The S&P 500 Index climbed more than 4.5 percent in the holiday-shortened week before taking a breather on Friday.

Weaker-than-expected data points in the months of May and June mean that the U.S. economy is likely to grow at a slightly slower 3.0 percent annualized pace for 2010 and remain at that rate for 2011. Economists are not prepared to make drastic cuts in their projections due to several factors. Despite some poor headline results, there have been signs of labor improvements among the private sector, such as rising payrolls and a pickup in quarterly average income growth. The Conference Board Employment Trends Index, which takes into account eight labor-market indicators, was up 0.6 percent in June, the eleventh consecutive increase. More important, the fact that the Federal Reserve is keeping interest rates at such low levels well beyond expectations means that credit and housing markets will receive support even longer than was projected.

As I mentioned last week, there is a great divergence between the long-term valuation of government bonds and the S&P 500 Index. According to Bianco Research, this disparity has now reached historic levels. Stocks have underperformed long-term Treasury bonds over a rolling 20-year period, something that has happened only twice in the past 140 years. While this would appear to turn on its head the widely held theory that stocks always outperform bonds in the long run, there is bound to be a reversion in the making. Although there remains a risk of economic stagnation ahead, the great bull market in bonds is long in the tooth at more than 28 years.

Moreover, at multiples of 10 times estimated 2011 profits, it is rare to find stocks this cheaply valued when earnings estimates remain as robust as they are. We must contrast this environment with the one prevailing in late-2002 or early-2009, when the economic picture may have been murkier or the financial crisis was still unfolding. But given current multiples and the sudden preponderance of bears reported by investor surveys and the media, there is clearly a growing skepticism over analysts’ forecasts. Yet with the S&P 500 yielding 8 percent and the 10-year note yielding 3 percent, the gap is as wide as it has been since the late 1970s. Typically this bodes well for future S&P 500 returns, but we may need a little more economic proof before we are in the clear.

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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.

As your fiduciary at Dion Money Management, we believe that it is crucial that we are aware of any changes to your investment needs. If you are experiencing a life changing event or a change in your risk tolerance or investment objectives, please contact us directly so that we can discuss your individual situation and make any changes to your investment accounts that are necessary. We pride ourselves on creating an investment portfolio that is suitable for your unique needs, and we would be happy to review all of your investments at any time so that you are positioned in the most prudent manner.

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Although I was not surprised that the Federal Open Market Committee (FOMC) left interest rates unchanged on Wednesday, I believe their accompanying statement was more downbeat than investors expected. Not only did it tone down its remarks regarding economic recovery—choosing to call it “proceeding” rather than “strengthening”—other parts of the statement alluded to greater uncertainty regarding housing and employment. Overall, with the expiration of emergency monetary measures already underway, the limits of policy stimulus may have been reached, and the true strength of the recovery will now be tested.

In fact, on Tuesday, data showed that existing home sales dipped 2.2% in May, meaning that the benefits of the credit extension were waning faster than expected, or had less of an impact. Nevertheless, home sales have climbed 25% since their lowest point in January 2009. Meanwhile, the Federal Reserve’s view on employment may have been affected by the token headline gain of 431,000 new jobs in May, which was dominated by census hiring, while private payroll hiring was a paltry 41,000. The hope is that the census had a temporary crowding-out effect, similar to previous cycles, as private employers competed to retain or add skilled workers to their ranks.

The Fed’s choice of language, however, reflects the lull in activity that the stock market has already priced in since late April. Stocks have performed better over the past three weeks and have managed to repair some of the damage inflicted by the May correction. Yet, just as it took the S&P 500 Index three attempts to poke above its 200-day moving average, the 50-day moving average may prove significant resistance as well. On Monday the S&P 500 attempted to push above this level on an intraday basis, but the index turned down and closed lower on the day, creating a bearish reversal that may take time to repair. Other indices, such as the Nasdaq, ended six consecutive up days and a seven percent gain with its own reversal, which set the tone for the remainder of the week.

Although the earnings season officially gets underway in less than three weeks, when Alcoa announces its results, some companies will soon begin the process of pre-announcing their earnings for the second quarter. These results will be paramount for analysts and may, in the end, have the most impact on market levels in coming weeks. The expectation is that corporate profits will remain solid in the second quarter, but that positive surprises may be harder to come by now that the effects of cost cutting and productivity improvements have run their course. The forecasts for 2011 may garner the most attention as investors assess what the next market catalyst will be.

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