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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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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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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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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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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As I have outlined in recent weeks, the risks facing investors have been plentiful, especially given the fragile nature of the recovery, but the debt problems facing Europe have been at the forefront. Among the numerous threats to growth there, systemic risk due to a bank failure or sovereign default has been of paramount concern. However, successful bond auctions in Spain and positive economic results from Germany, France and Italy have helped to stabilize the euro and allowed stocks to rebound.

Stability in the euro will go a long way to preventing another key risk to global markets—the overreaction of sentiment. Just as investors can reduce their exposure to troubled markets and currencies, banks can quickly tighten credit, companies can reduce their investment and hiring plans, and consumers can stop spending. Nevertheless, the European Central Bank raised its 2010 growth outlook from 0.8% to 1.0%, while G-20 finance ministers announced that global growth was emerging stronger than expected.

During periods of heightened volatility such as this past May, the role that diversification plays becomes abundantly clear. Many investors think of diversification as a way to avoid stock-specific exposure, such as a sharp decline in a single company like BP in recent weeks. Although diversification is especially beneficial when attempting to overweight a sector like energy, which is expected to account for half of corporate earnings growth in the second quarter, research has also shown that a diversified portfolio of stocks, bonds and other assets can reduce volatility and increase returns over the long term. A portfolio that includes other assets such as bonds not only can increase average monthly returns with less risk, but it also can reduce volatility, especially if the market were to trade within a tight range while it builds a base for the next leg higher.

I also believe exposure to dividend-paying stocks, which are an increasingly valuable portion of total return, will improve results over time. I continue to advocate using funds such as Federated Strategic Value (SVAAX) for exposure to high-yielding stocks and Federated Strategic Income (STIAX) for diversified bond exposure.

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Volatility is likely to remain high in the near term as investors digest economic data at home and abroad. A lot of analysts have been discussing the TRIN index (short for Traders’ Index), which measures breadth and volume of the market. Recently, the index has spiked and the 10-day average moved above 2.5, a level not seen since March 2007. This shows that volume in declining stocks is greater than volume in rising stocks. In 2007, the market went on to reach new highs, proving that TRIN might be a better indicator of short-term selling than the future direction of the market.

The correlation between stock multiples and corporate yields—a relationship that has been fairly consistent over the past seven years—has broken down in recent months as investors have become more risk averse. With stocks trading at around 12.5 times future earnings, equities appear cheap relative to bond yields, meaning that investors are discounting slower economic growth or a poorer macro environment (i.e. rising interest rates).

However, manufacturing data remains positive both in the U.S. and abroad. Among U.S data from last week, the Institute for Supply Management (ISM) manufacturing survey for May of 59.7 beat expectations and 94 percent of industries reported growth. Elsewhere, manufacturing orders showed surprising strength in Germany for the second successive month, and the export-driven Taiwan reported a 10.1 percentage improvement from the preceding month.

The average correction within a bull market since 1927 has lasted 104 days, so at less than 50 days the current correction’s duration is still just half the average length. What feels different this time is that the approximate 14 percent decline is already inline with the average 13 percent drop over previous periods. I continue to advocate diversified portfolios for corrections such as these. Research has proven that portfolios consisting of stocks and bonds are less volatile and achieve higher risk-adjusted returns than portfolios investing in only one asset class, such as the more-volatile equities.

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Now, just as markets had been overbought in April, with a high percentage of stocks trading above their 50-day moving averages, an about-face has occurred and the vast majority of stocks are below their short-term averages. Meanwhile, some have even sunk below their 200-day moving averages—a sure sign that the initial selling was overdone. And sure enough, equity markets have rebounded in early June.

But after the worst May since 1962 and with much of the bullishness sentiment wrung out of retail investors for the short term, are stocks more appropriately valued now? The S&P 500 is now trading at 11 times future earnings, which is just below its 25-year average. However, this is still higher than the eight times future earnings seen in March 2009, when this rally began. Yet corporate earnings continue to surprise to the upside. In fact, the first quarter results were the strongest in terms of surprises since recording this data began in 1987.

Investors, therefore, are left to ascertain not only whether the economies of Asia and North America—which are showing solid signs that self-sustaining recoveries are under way—can flourish from here, but whether stock valuation levels are appropriate given the massive rebound from March 2009 lows. The response by most analysts is yes, even from those that predict structural problems may eventually unhinge the markets in the future. The belief is not only that economic data will continue to surprise to the upside of expectations, but that most earnings projections are too conservative, thereby allowing for another two to four strong earnings seasons ahead.

This week, economic data supported my belief that the recovery still has some momentum. Although the employment report for May was a mixed bag, inflated in part by temporary governmental hiring, private payrolls increased and manufacturing hiring continued to trend up. Other data, such as the ISM non-manufacturing index was flat but remained well in expansionary mode.

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But once the market sentiment went from bad to worse and the selling accelerated, traders feared that many of the reliable bullish patterns, such as low volatility and appreciation of riskier assets, were coming undone. Whereas a lack of volatility told traders to press riskier bets, high-volatility pressured them to shrink those trades and seek safe havens like Treasury bonds.

Although the faltering euro has remained the focus of global investors, the fear of another economic downturn here or abroad would have the widest implications. While economic data has been mixed over the past month—from positive manufacturing surveys to falling building permits—they represent signs of slowing momentum rather than a reversal of growth. And just as one data point does not make a trend, the U.S. recovery remains on track and deserves the benefit of the doubt, especially when gross domestic product for 2010 and 2011 is still projected to grow around 4 percent.

What we have experienced in May is a mix of seasonal weakness—in which traders exit profitable positions and reassess the health of the market—and a rotation from some of the riskier trades toward quality or undervalued positions. Recent activity is not so much a response to weakening growth but an attitudinal change to risk and the desire to quantify corporate earnings projections and S&P 500 target levels. In other words, rather than investors feeling complacent to potential risks, they are taking stock of potential headwinds, which I still believe have yet to derail the global growth story.

Moreover, the timing of this correction is fairly typical relative to historical patterns. According to Fidelity Investments, there have been 20 corrections during bull markets that did not develop into bear markets. Although this reversal arrived 3 months earlier than the overall average of 17 months, the preceding gains this time were 80 percent versus the average of 57 percent, so one could argue that a correction was overdue. What has made it more memorable, however, is that it took half the time, just 24 days, to surpass the 10 percent decline threshold.

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As I mentioned in last Friday’s email, the EU bailout package lacked any stimulus to ensure that the weaker nations could grow their economies. However, despite all of its woes, the European gross domestic product is expected to remain positive in 2010, and certain nations such as Germany will benefit enough from the weaker euro to offset declines elsewhere. The risk is that a prolonged crisis, or fear thereof, will cause businesses and consumers to retrench and further prolong the recovery.

At this point, I still contend the selling will be confined to a seasonal correction that often occurs around May. Nevertheless, what is likely to emerge in the meantime is a rotation to quality, a trend that I have been anticipating for months now by holding large positions in such funds as Federated Strategic Value (SVAAX). During the summer months especially when trading is light, investors are likely to sell more of their volatile, high-beta positions, such as small-cap stocks, which have already outperformed even longer than previous rallies would have indicated was probable. Certain measures of quality, such as valuation, profitability, and dividends, are attributes that evade many of the smaller stocks. For clients interested in more stable value positions, I continue to advocate allocating a portion of conservative assets to Federated Adjustable Rate Securities Fund (FASSX).

The troubles that pervade the eurozone are also likely to warrant a rotation away from lower quality foreign markets toward the U.S. market, which continues to demonstrate the sustainability of its own economic recovery. In spite of the European Union’s measured response to the sovereign-debt crisis and its commitment to the euro, the currency is likely to remain weak for the remainder of the year, if not longer. Although a weaker euro alone might only shave 4% from S&P 500 earnings this year—not as significant during a year of 60% earnings growth—a protracted period of euro weakness or the risk of a stagnant European economy in the near term might be enough to keep many investors focused on the U.S. until better valuations present themselves abroad.

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