Dion Money Management Blog   Money Management for Retirees and Their Families

After reaching severely oversold levels this week and hitting another key support level, the stock market bounced up and down in volatile trading. Although the trading activity may remind investors of the financial crisis, the daily spread between highs and lows over a recent five-day trading period was only half as large. The severity of the slide, however, did rival those experienced in 2008. The silver lining is that whenever the market has reached these oversold levels in the past, it has historically been higher over the next six months.

Although one could argue that the downgrade of long-term U.S. government debt was not a surprise, the market’s reaction on Monday would indicate that the timing, in fact, may have been. All three main rating agencies had warned that the U.S. debt rating was on their watch lists with negative outlooks, but Standard & Poor’s was quite clear about what type of concerted policy action and spending cuts that it was looking for right off the bat. So, when Congress came up short with only $2.4 million in definitive cuts, and in the process displayed a strongly divided Congress unable to rise to the occasion, investors should have counted on a downgrade. But the fact that it came just one week after the debt-ceiling agreement, and that it capped a week of widespread equity selling, caught many off guard.

It is often difficult to extricate the real reason for a correction, especially when many factors are often converging to tilt the market in one direction or another. Last week, a combination of factors, including weaker economic data, the apparent end to fiscal stimulus, and the potential downgrade were all reasons enough for investors to become more cautious. But when trying to price-in an unprecedented market event—the act of losing what has been deemed a “risk free” asset for the past 70 years—it can be difficult to gauge the potential market reaction, which all at once must take into account anything from complex financial modeling to public reaction.

The good news, however, is that Treasuries are still the risk-free fixed-income asset of choice, at least based on this week’s trading activity. Even though the announcement came just as the 10-year Treasury yield had fallen to a nine-month low of 2.5%, investors came out Monday clamoring for safe haven assets and Treasuries, in particular. As we saw during the financial crisis in 2008, Treasury securities can maintain their safe-haven status even in extremely difficult times. Treasuries are viewed as high quality, and no other government bond market can match the size, liquidity, and transparency offered by the U.S. Therefore, governments and institutions alike will continue to turn to this market for their high-credit needs. Moreover, the U.S. boasts the largest economy in the world and still holds the world’s reserve currency.

Given the severity of the stock-market slide in recent weeks, investors of all stripes have turned bearish, and it would appear they are increasingly pricing in the chance of a recession. The advent of a double-dip recession would likely take the markets even lower from here, however; so with the help of research from Federated Investors, I thought it would be good to review some common recessionary signposts, none of which are flashing dire warnings just yet.

For one, the yield curve almost always inverts as early as 14 months prior to a recession, but the curve remains upward sloping even with the recent rally in Treasuries. Moreover, recessions are often induced by the Federal Reserve, once it moves toward a tightening bias. Yet the Fed has maintained a well-advertised campaign to keep interest rates near zero—even extending their commitment to 2013 in an announcement this week—as well as an expansive balance sheet in order to keep credit available and the economy well-supported. Unemployment also remains at elevated levels rather than entering a trough; this is not usually the case when the economy is shifting gears or signaling a recession.

The next few weeks could be pivotal in determining the direction of the market. Macroeconomic concerns need to subside, so that investors can focus on incoming economic data and assess whether corporate earnings can hold up again this quarter. If so, we are likely to find support at these levels and, given that valuations are attractive, the bull rally should continue.

The stock market rebounded this week as news of better corporate earnings took center stage once again. The S&P 500 bounced off its 50-day moving average and moved back toward its July highs, but it took eight days of seesaw action to recapture last week’s lost ground. In addition to earnings, there was positive news from both manufacturing and housing indicators to push bullish sentiment higher, yet it still remains below April levels after a similar stock market rally.

The rebound from June lows has occurred even though sovereign debt issues remain largely unresolved, particularly among the U.S. and European nations. The ceremonial dance on Capitol Hill has meant that legislators have made little headway in the ongoing debate over whether or not to extend the federal debt ceiling, even if a compromise is widely expected. The delayed agreement, however, which is meant to exact the most amount of leverage on the opposing side, has only hurt the U.S. dollar and kept it from rebounding.

Meanwhile, the behavior and relative strength of the euro over the past few months, even in light of heightened chaos amid troubled European nations such as Greece, Italy, and Portugal shows that there still remains strong underlying demand for euros and the bonds of more stable nations such as Germany and France. This week EU leaders held an emergency summit, releasing a draft statement that announced an orderly default for Greece was possible, as well as an expansion of the rescue fund that could be tapped to recapitalize banks and stave off contagion if necessary.

The debt-ceiling impasse here in the U.S. has also hampered consumer confidence, although you would not know it by watching the retail numbers. Last Friday’s release of the University of Michigan’s sentiment brought confidence readings down to the lowest level since March 2009. Moreover, the publicity over the budget battles brought public discontent to new heights for the Obama administration, with more than 50 percent of respondents rating government economic policies as “poor.” Only five other surveys in the past 50 years have resulted in a majority voicing a negative opinion as high as this. However, just as similar policy debates surrounding the Congressional elections resulted in a decline in confidence, a rebound is expected once a deal is struck, even if it is short on specifics.

The contrasting rise in retail numbers this week is a classic case of, “watch what I do, not what I say.” The ICSC store sales index rose for the fourth consecutive time since mid June and is now up more than 3.1 percent month over month, and the annual pace continues to accelerate. This combined with a positive reading from the Philadelphia Fed’s manufacturing survey and a stronger index of leading economic indicators (LEI) to provide hope that the summer soft patch will be cut short. With earnings season now in full swing, we will soon know whether or not companies can continue to beat estimates and provide upward guidance for the rest of 2011.

Disclaimer

The late-June rally, which brought stocks back toward 2011 highs, lost momentum this week. Even though that rally had been broad, pulling all sectors along with it, cyclical stocks had seen the largest rebounds. Some of those gains were reversed this week when those sectors sold off the most. The pattern this week seemed to be one of intraday highs giving way to bouts of weakness and falls of more than 1 percent. Whenever this has occurred over the past two decades, the market has posted better than average returns in the weeks and months ahead according to Bespoke research. Therefore, we still have a good chance of seeing strength return to the market in the short term.

It is not uncommon to see sectors converge at this stage of the business cycle. As the profit recovery has matured, market returns can moderate and leadership can change. Investors will often seek out high-quality stocks that may have attractive valuations and sustainable dividend policies, offering higher returns on equity. This is especially true if earnings growth begins to wane, when there is a more balanced performance between defensive and cyclical sectors.

The question is whether we have finally reached the stage at which earnings growth will moderate. Earnings season is underway, and the major companies that have reported so far are reporting results that are in line or better-than-expected. The expectations are that continued momentum in manufacturing and ongoing strength in emerging markets will be underlying themes. Even though lower credit costs for banks is considered positive, a high-profile write-down by Bank of America has weighed on the financial sector. As always, overall guidance is expected to be cautious in this post-crisis environment.

Most economists and analysts were focused on “Fed speak” this week, including the semiannual testimony before Congress by the Federal Reserve chairman, as well as the release of the June Federal Open Market Committee (FOMC) minutes. Released on Tuesday, the minutes revealed that committee members maintained a strong emphasis on inflation, especially by those who would advocate for additional monetary policy accommodation if the threat of deflation returned. The FOMC remains concerned that a slowdown in manufacturing would be broad based.

However, the most recent economic data released this week offered a fresh perspective on those concerns. Both the consumer price index (CPI) and the produce price index (PPI) illustrated that inflation was alive and well. Even though the CPI fell, core prices were higher and the year-over-year core measure climbed to 2.5 percent from just 0.8 percent last December. The core PPI also escalated, pushing the annual pace to 2.4 percent, with much of the change coming in the past six months. This pressure in core prices will make it harder for the Fed to engage in the same type of monetary easing.

Nevertheless, Fed Chairman Ben Bernanke did more explicitly mention the possibility of additional quantitative easing during his live testimony before Congress on Wednesday. Stocks rallied on the news, and bond prices fell. The comments stem from his outlook that any persistent economic weakness or deflationary risks would call for an additional response, which may or may not include direct security purchases. What the market has overlooked, however, are his previous comments on Fed research showing the limited effects of quantitative easing in terms of job growth, perhaps because it is viewed as supportive of equity prices.

Although volatility returned in earnest this week, the broad S&P 500 should post a weekly gain if it closes above 1,271 today. This would mark the first week in seven that the index managed to finish up. The slide has taken stocks close to their 2011 lows, but the S&P 500 remains above its 200-day moving average. And even though the index remains above the March low, more stocks are trading below their 50-day moving averages than at that time, reflecting a period similar to last June when sovereign debt issues were also in the news.

Even as the S&P 500 flirts with returning to negative territory for the year, this is nothing out of the ordinary. In fact, over the past 20 years, the broader index has turned negative at least once in every year except 1995, the most bullish year in the entire sample, and the average price change from the start of the year to the lowest point was a 10.4 percent decline.

These three summer months beginning in June often provide a challenging market environment for long-term investors. When analyzing seasonal summer weakness, however, it is important to note that pre-presidential election years such as this one are much stronger, with cumulative gains of 2.92 percent on average since 1929. Although history does not always repeat itself, there remains an historic upward bias to this year, nevertheless.

Disclaimer

Up until this week, volatility measures have not indicated a growing sense of fear or panic, as they have in previous corrections over the past two years. In fact, risk appetite has been quite resilient. This is, in part, a testament to the fact that investors now have higher confidence in the outlook for a sustainable recovery. Not only have corporate earnings continued to grow robustly over the past year, but both macroeconomic and fiscal policy responses have been measured and well-timed to keep economic growth on track.

The question is whether we can expect the market to respond in similar fashion to match last year’s extensive rebound, given that not only are we further along in the business cycle, but we cannot count on policy encores due to the heightened political pressure. Nevertheless, even in light of this more subdued backdrop, the stock market should have other sources of support. For example, the business cycle may be more mature, but the high levels of corporate earnings and profitability remain.

Also, valuations have not run amok, meaning they are in line with underlying fundamentals. It could be that they reflect ongoing risks, but world markets are trading at less than 12 times forward earnings estimates. This is well below the average 16 multiple, or even a lower multiple of 15 if we account for frothier markets like the tech bubble or crashes like the recent financial crisis. Therefore, barring any prolonged risk aversion, there is room for multiple-expansion and a re-rating of stocks by investors, allowing for additional upside once the market resumes its ascent.

The stock market managed an about-face this week on the back of strong corporate earnings results. Although investors have spent the past two months worried about a variety of global issues, including a potential downgrade of U.S. debt announced on Monday, some high-profile reports from companies such as Apple, Intel, and General Electric were enough to convince them to get back on board.

Now that nearly 25 percent of S&P 500 market capitalization has issued results for the first quarter, earnings are on-track but slightly weaker than the prior quarter, with 54 percent of companies beating their earnings-per-share estimates. Strength is coming from information technology and healthcare firms, while financials and consumer discretionary names have disappointed.

This week Standard and Poor’s affirmed the sovereign credit ratings on U.S. debt, but the agency lowered its long-term outlook from Stable to Negative. While the agency stressed that the U.S. economy is diversified and adaptive, as well as supported by effective monetary policy and a global reserve currency, the government’s failure to address fiscal imbalances and the approaching debt ceiling raises concern that these issues will not be resolved in a timely manner. Although the change in outlook should not have come as a surprise given our response to the most recent financial crisis, stocks reacted unfavorably to the news.

Fixed income investors are rightfully concerned that higher interest rates are finally on the horizon. As I will discuss in this month’s client letter, it is still too early to know which countries will be able to grow their way out of current debt problems and which ones will succumb to higher interest rates and inflation. The U.S. is in a better situation than many European nations, for example, because it can more easily raise taxes and investors are more willing to buy U.S. government debt. Interest rates have risen from where they were at the depths of the crisis, but they remain below 2007 levels and in a 29-year downtrend until confirmed otherwise.

In the U.S., investors must also contend with the Federal Reserve’s planned ending of its quantitative easing program (QE2) in June. Although this does not necessarily mean that the Fed’s accommodative stance will change, or even that their balance sheet will shrink, it should reduce the downward pressure on interest rates. Yet, the Federal Funds rate will likely stay near zero until 2012, so any move in rates should be moderate over the next two months provided there are not any surprises coming out of Washington.

One of the best ways to deal with a rising rate environment is with senior loans, or floating-rate securities. These investments can help to protect fixed-income investors from the risk that rising interest rates will lead to capital losses among their bond holdings. Senior secured floating-rate loans periodically adjust their yields based on the general level of interest rates. As a result, they tend to retain their value when rising rates make other bonds less attractive. I may utilize funds such as Federated Floating Rate Strategic Income (FRSAX) or Fidelity Floating Rate High Income (FFRHX) in the months ahead. In the event of higher volatility or higher default rates, however, these funds will come under pressure and trade more like high income funds, so they are not antidotes to risk.

The stock market remained calm this week but gained little ground, as investors contemplate the prospects for economic growth and investment returns amid the swirl of geopolitical and policy headwinds. Although the jump in oil prices remained squarely in the headlines this week, economic data continues to show that the current recovery is resilient and self-sustaining.

Unfortunately, some of the uncertainty that sparked widespread selling last month still remains. The unrest in the Middle East shows little evidence of waning, and oil prices will stay elevated as a result. Higher energy prices will threaten consumer purchasing power and confidence, two elements that had continued to strengthen in recent months. Even though nominal consumption remains robust, real consumption data released through February showed a significant deceleration to 1.5 percent from the heady 4.1 percent level recorded last quarter. This was due to a rise in consumer price inflation. Also, both bellwether consumer sentiment indices saw declines in March.

Yet factors supporting ongoing U.S. growth include the improving labor market, which is seeing strength across many different indicators. Nonfarm payrolls have climbed an average of nearly 160,000 per month so far this year, and there has been a pickup in the rate of hiring. Initial jobless claims are trending down, and the unemployment rate has dropped a full percentage point over the course of the past four months. At the same time, personal income jumped in January due to lower tax withholdings emanating from the 2010 tax bill. These improvements are necessary components of the positive feedback loop that inevitably supports consumption levels via better employment and higher income. The end result is an economy and a recovery that is more resilient and on firmer ground.

The business survey results over the past two weeks have reflected this strength, remaining at elevated levels despite losing some ground. The manufacturing ISM index slipped slightly to 61.2, but this still signals a booming 10 percent growth rate. For its part, the latest non-manufacturing ISM survey fell back to 57.3, its first decline in six reports. The recent disaster in Japan and fears over the supply-chain disruptions appeared to weigh on respondents’ outlooks. Still, by combining the two reports, the results are consistent with a gross domestic product (GDP) of nearly 5 percent. The strength of last week’s payroll data and other corroborating employment reports provide further support to the notion that any soft patch from March would be temporary. The latest Conference Board survey of CEOs indicates that those respondents are more bullish than they were last year, with half intending to ramp up hiring now that their assessments of economic conditions are more upbeat.

As for the stock market, its own recovery from the depths of last month has been swift and breadth has improved. More than 70 percent of the S&P 500 stocks sit above their 50-day moving averages. While this remains below the level seen last fall, investor sentiment has returned to previous bullish heights. In fact, it was only higher in 1987 and 2003 before stocks entered into a period of consolidation after similar multi-month rallies.

In spite of the heightened volatility and uncertainty that forced a market slide through the middle of March, stocks have performed well and recaptured nearly all of that lost ground. The S&P 500 gained more than 5 percent over the first quarter and sits near its post-recovery highs. Although much has changed in just three short months, the fundamentals supporting stocks remain quite good. These include reasonable valuations, positive corporate finance, accommodative monetary policy, and a healthier economic backdrop.

One driver behind the market’s resilience in the face of global turmoil is the outlook for corporate earnings and the health of company balance sheets. The earnings improvements over the past two years have been a principal driver in the stock market’s recovery. But as this economic cycle matures, firms may be faced with margin pressure and a loss of earnings momentum. While this pattern is a normal one, it is not without implications. A primary consequence is that cyclical stocks may perform more inline with non-cyclical stocks and defensive sectors.

Yet, other drivers may still emerge that would allow for certain sectors to outperform. One trend during the fourth quarter was that companies returned 55 percent more cash to shareholders than in the prior year. In the past, I have discussed the ability of firms to increase their dividends to shareholders, yet the rise in corporate profits and concomitant spike in cash balances also allows companies to buyback their shares, providing another way to return capital to shareholders. While dividend payouts increased by 15 percent over the prior year, buybacks jumped by 128 percent.

Moreover, firms are still only returning half of what they returned during the last bull market, leaving even more room for share buybacks. Whereas this type of activity dropped to zero during the recession, as companies exercised extreme caution and boosted their cash retention, it has the ability to grow sevenfold, just like it did during the last expansion. While net income since the recession has been steep, payouts have not kept pace on a percentage basis. Therefore, companies have the resources and the desire to boost their payouts and improve their return on equity now that business confidence has returned. Some of the sectors that can benefit the most include energy, materials, and technology, due the combination of higher cash levels, better earnings, and lower current payout ratios, especially relative to their averages. Although some companies may also feel the need to invest for future growth, low interest rates should allow them to issue debt, while instead using cash to boost payouts and their share prices.

So, while increased policy risk will mount once the Federal Reserve is ready to reverse its stimulus, and even though overall uncertainty will persist until Middle East turmoil subsides or European debt woes are adequately addressed, the supportive backdrop for stocks remains in place and equities should see higher levels from here.

Despite the fact that financial markets remain largely unsettled due to a variety of global events, the U.S. stock market rebounded this week and volatility subsided. The S&P 500 climbed back above its 50-day moving average, and the number of individual stocks rising above their own 50-day averages reached more than 55 percent. Recent events have many analysts wondering whether the economic momentum can continue and slight revisions to 2011 projections have begun to emerge.

Just as the nuclear crisis in Japan was finally appearing under control, the focus shifted back to the Middle East, where tensions and conflict increased. The United Nations Security Council passed a no-fly zone in Libya, with several UN members initiating air strikes against forces loyal to the Gadhafi government. The rhetoric on both sides implies that the conflict could be prolonged, raising uncertainty about the impact on oil prices and global output.

Nevertheless, the military strikes relieved the uncertainty stemming from inaction, which tends to support stock markets. We have seen this countless times—volatility subsides once the threat of conflict is realized. So far, oil prices reflect the disruption in Libyan supplies, even though the oil infrastructure is largely intact. The risk that conflict becomes protracted or spreads to other oil-producing nations remains unknown. In the meantime, higher oil prices have begun to weigh slightly on estimates of real gross domestic product (GDP) in the U.S., even if global GDP growth is likely to remain unchanged due to growth abroad.

Energy prices have pushed forecasts of consumer price inflation (CPI) higher in 2011, rising from 1.8 percent to 2.3 percent. This has caused real U.S. GDP estimates to fall slightly, but nominal GDP could remain the same, accounting for inflation. As a result, it is possible for corporate earnings to meet expectations, and analysts have not yet reduced their S&P 500 targets. With another round of earnings just around the corner in April, we will see if companies can attain the $96 earnings per share that is currently projected. While some firms may not be able to raise prices to cover higher input costs, oil and gas companies will have higher earnings, resulting in a net positive for the overall index level.

Emerging markets have made a surprising rebound amid the recent crises. Concerns over inflation and overheating economies pushed investors to reduce their exposure in late 2010 and earlier this year, realizing that governments would take steps to tighten their monetary policies. Yet the crises have allayed some of these concerns now that the risk of a soft patch has increased, relieving some of the need for aggressive responses. As always with economics and the market’s response, there are multiple variables to juggle at any one time. I continue to focus on the U.S. economy, however, which has shown more positive economic surprises in recent months; even another soft patch is unlikely to derail the global recovery.

Stocks seesawed their way through the week, as oil prices moved higher and public finance issues dominated the news cycle. So far the slide this month has been marginal after a multi-month advance allowed the S&P 500 to double from its 2009 lows and brought the index firmly above its long-term moving averages. While the number of individual stocks above their own 50-day moving averages has begun to wane, the current 62 percent is above the 58 percent level seen during November’s slide, showing that market breadth is still healthy.

Investors continued to assess the political turmoil in the Middle East and its potential to spread to other critical oil-producing nations, such as Saudi Arabia. While analysts acknowledge that oil prices could spike to $120 per barrel given the uncertainty of the outcome, today’s $100 level is a likely year-end target once the current disruptions are resolved. Although it would probably require a price of $140 per barrel to spur a possible recession in personal consumption, even oil at $110 is high enough to weigh on equity markets, which translates to a 40 percent year-over-year increase. So although current prices are a concern, they are still below some critical thresholds and much lower than previous spikes in the past 10 years, or during the 1970s.

Federal Reserve Chairman Ben Bernanke acknowledged these commodity pressures during his semiannual monetary policy testimony before Congress this week, stating that higher prices would represent a threat to economic growth and price stability if sustained or inflation expectations became “unanchored.” However, he also noted that recent monetary policy decisions have had a “beneficial effect” on the recovery, judging from the stock market’s response and the improved economic outlook. Bernanke also acknowledged that the recovery underway in consumer and business spending appears self-sustaining, even if a longer period of job creation is still necessary to reaffirm the improving employment trends.

Those trends were reaffirmed on Friday when the latest employment report from the Bureau of Labor Statistics (BLS) was released. The unemployment rate in February dropped to 8.9 percent even as the labor force grew. The private payroll number increased by 220,000, although the overall payroll data was less due to the continued drop in government jobs at the state and local level. Government is expected to act as an ongoing drag on employment levels and overall growth in 2011 as states face budget deficits of $130 billion.

Nevertheless, the private payroll results reflect improving labor conditions, which are corroborated by regional employment indices, as well as the ISM and ADP surveys. The ADP data, also out this week, showed an acceleration of payroll growth, particularly as it relates to small- and mid-sized companies, which are slowly reflected in the BLS data. Jobless claims also dropped this week, bringing the four-week average down to 389,000.

Meanwhile, both the manufacturing and nonmanufacturing ISM indices gained ground in February. The employment indices of each report were positive and suggest a faster pace of employment growth in the months ahead. The reports also indicate that an acceleration in gross domestic product (GDP) is underway due to a large rise in the production index and higher durable goods orders.

Disclaimer

The strong rally in stocks has stalled over the past three weeks, as investors take a wait-and-see approach to recent developments and allow for much needed market consolidation. Political unrest, high commodity prices, monetary policy concerns, and natural disasters are putting pressure on stocks, but so far volatility has been low and the setback has been limited. The primary risk is that any one or all of these issues combine to force another soft patch in the economic recovery, even as global economic data has continued to improve up until this point.

The political unrest in the Middle East has been front and center, particularly due to its impact on crude oil prices. Although the initial unrest in Tunisia and Egypt put upward pressure on prices, the impact on the supply/demand balance was minimal. The loss of output in Libya, however, has been more problematic, due to the fact that its total output accounts for 2 percent of global production. While this is a small percent of total supply, it does impact OPEC’s spare capacity. The reduced potential to meet future demand, as well as the uncertainty over further unrest or contagion, has built a risk premium into current prices. If oil increased to $120 per barrel, total oil expenditures could reach 6 percent of global gross domestic product, a level not seen since the 1980s according to the International Energy Agency. Yet, based on oil futures, investors are viewing the current spike as temporary.

Japan’s earthquake and the resulting tsunami put the risk of natural disasters back into the spotlight. The 8.9 magnitude earthquake on Friday was the worst for Japan since the 1995 quake in Kobe. Although it was devastating to watch the destruction and tragic loss of life today, the Kobe event was likely far worse in terms of deaths. In the end, its impact on economic indicators such as industrial production was less meaningful than expected, even though the Nikkei lost 8 percent in a matter of a few days and slid further through midyear. Today’s impact will depend in part on the government’s response in terms of economic and monetary easing, as well as the movements of the Japanese yen and the overall global recovery. Direct exposure to Japan is limited to the ICON Asia-Pacific Region Fund (ICARX), which has 25 percent of its assets allocated to this nation.

Domestic economic data was light this week, but we did receive insight to rising small business confidence and a wider trade deficit. The NFIB small business optimism index rose another 0.4 points to 94.5 in February, which is the highest level since February 2007. Although capital expenditure plans were unchanged, the expectations for hiring and sales improved. As for the trade deficit, it widened with both imports and exports growing, reflecting stronger consumer demand.

Disclaimer