August 2010 Market Commentary
From the desk of David Reilly, CFA
Decision Critical Resources, Inc.
September 3, 2010
Financial markets across the globe took a terrible beating in the month of August as
risked‐based assets, including stocks, oil and the Euro, all pulled back significantly on the
realization that U.S. economic growth had crawled to a near halt – raising fears of the
dreaded double‐dip recession. Treasuries rallied as the yield on the 2‐year Note fell
below 0.50% and the yield on the benchmark 10‐year Note fell below 2.50%. The dollar
and high quality credit were also able to rally as the greenback benefitted from its safeharbor
status and investors searched for yield in an environment of disturbingly low
interest rates.
In U.S. markets, stocks turned one of their worst August performances in memory as the
Dow Jones Industrial Average shed nearly ‐4.0% and the S&P 500 lost ‐4.5%. With high
beta exposures taking the brunt of August’s selling pressure, small cap stocks were hit
hard as shown by the ‐7.4% decline in the Russell 2000. At the sector level, financial
stocks, which are viewed as a bellwether for the broader economy fell ‐7.9%, which
hammered value indices as shown by the ‐6.8% drop in the S&P 500 Pure Value Index.
Deep cyclical stocks such as industrials were next on the hit parade as the shown by the
‐7.3% decline in the S&P 500 Industrials Index. Tech stocks were also hit hard as
evidence of a pullback in business capex – which has been focused almost exclusively on
technology – began to wane. The ‐7.2% decline in the S&P 500 Technology Index was a
major contributing factor to the ‐6.1% decline in the Nasdaq Composite.
The odds of a double dip recession – which we still do not anticipate but will admit have
increased – were driven by a laundry list of well known factors as well as some new
worries. The labor market remains essentially moribund. The economy is still shedding
jobs although the private sector has started to add jobs in a tentative way. Private
payrolls increased by 107,000 in July and by another 67,000 in August. Although these
numbers exceeded beaten down estimates, they are a far cry from the kind of numbers
needed to bring down 9.6% unemployment or restore the 8.4 million jobs that have
been lost since the beginning of the recession in 2007. Moreover, the duration of
unemployment is at never before seen levels which is keeping consumer confidence low
and fragile. Income growth is stagnant and retail sales remain soft. A big part of the
stalemate in the labor market is the lack of confidence by small business which,
struggling with near zero top line growth and regulatory shock is in no mood to hire.
With Q2 GDP growth revised down to +1.6%, the Fed is now talking openly about
additional quantitative easing – a.k.a. printing money. The last item on the list of the
familiar is housing. In the waning days of August it was reported that existing home
sales plummeted ‐27% in June as government incentives designed to spur new home
sales expired. Even with mortgage rates at 50 year lows, it is abundantly clear that
government stimulus simply stole sales from the future.
Arguably all of these sobering dynamics were already discounted in asset prices and it is
reasonable to assume that the weakening of the remaining growth engines of business
capex, exports and inventory restocking was major factor in August’s sell‐off. With
exports slowing and imports still moving up, the trade deficit in June reached $8 billion,
its widest gap in nearly two years. Business investment also appears to be downshifting.
Non‐defense capital goods expenditures ex‐aircraft, a widely accepted proxy for
business investment, fell by 8% on an annual basis in July.
Most international equity markets fell in August although there were some interesting
divergences. Stocks in the UK essentially held their ground in August as Q2 GDP rose at
a +4.9% annual rate. On the other end of the spectrum, the Nikkei fell ‐7.4% as turmoil
in Japan’s political system offset strong export performance. In emerging markets the
engines of global growth – China and India – were the only major markets to record
positive growth in August with the Shanghai Composite rising +0.06% and the BSE
Sensex 30 up +0.72%.
With risk trades essentially grouped together, oil has become a proxy for risk and the
performance of the broader commodity indexes – which are dominated by oil ‐ has
followed suit. Front‐month NYMEX contracts for crude fell nearly ‐9.0% in August to
$71.92. It was only the performance of grains which have skyrocketed on the
catastrophe in the Russian wheat market and the continuing demand for industrial
metals which held the decline in the DJUBS Commodity Index to ‐2.56%.
Where’s the good news? Corporations have generated huge amounts of cash and are
sitting on an estimated $2 trillion some of which will undoubtedly be used for increased
dividends, buybacks and M&A. In fact, one –third of S&P 500 companies have increased
dividends in 2010.
In this environment we think stocks are likely to remain range bound. Productivity,
which is beginning to wane, is still high and earnings growth should remain robust. But
we see little on the horizon now that will result in top line growth. That keeps us in a
defensive mindset favoring large caps, high quality credit, exposure to the U.S. dollar
and low volatility alternatives which, on a relative basis, performed well in the difficult
month that was August.
David C. Reilly, CFA
60 State Street, Boston, MA 02106 www.decisioncriticalresources.com
Decision Critical Resources
August 2, 2010
In the struggle between gangbuster earnings growth and attractive valuations on one side and scary macro trends on the other, the bulls won out in July as stocks soared past worries about global debt levels, shell shocked consumers, a housing market that has fallen off a cliff and slowing exports.
On a total return basis, both the Dow and the S&P rose more than 7% while the Nasdaq Composite was close behind with a gain of +6.9%. As the month progressed deeper into earnings season, it became clear that the brutal, multi-year effort to cut operating costs continues to pay dividends. Seventy five percent of reporting companies are beating admittedly pared back earnings estimates and, despite worries about paltry top-line growth, two-thirds are exceeding revenue estimates as well. Moreover, earnings are coming in approximately 11% over consensus expectations, a margin well over what we have seen in recent quarters. July’s rally put year-to-date performance for the Dow into the black with a gain of nearly +2.0% while the broader S&P 500 had nearly wiped out earlier losses.
July’s rally brought visible evidence that the risk trade was back on – at least for now. Mid and small cap stocks essentially matched the gains of their larger counterparts as shown by the +6.9% jump in the S&P 400 Midcap and Russell 2000 small cap indexes. At the sector level, the global growth trade (energy, materials and industrials) lead the way higher with index-level gains ranging from +12.2% for materials stocks to +8.8% for energy stocks.
International stocks rebounded strongly with the benchmark MSCI EAFE Index gaining +9.5%. Although European markets rose, they generally lagged returns in the U.S. due to slower growth prospects, massive debt overhangs and fiscal belt tightening. Despite the headwinds, there was palpable relief that the vast majority of European banks passed their stress tests even if there were rumblings that the criteria were not as stringent as they could be. Sentiment turned up – particularly among business – and was aided, no doubt, by successful bond issuances by Portugal and Spain.
Emerging markets, on the other hand, generally beat returns seen in the U.S. with a gain of over +8.0% for the MSCI EM Index. EM returns were, however, uneven. Chinese stocks emerged from their long downswing as the country appears to have engineered a slowdown in runaway growth and achieved the much hoped for soft landing. This drove the Shanghai Composite up over +10%. Among the BRICS, this performance was exceeded only by Brazil, which rode the back of a powerful boom in commodity prices. The Bovespa Index rose +10.8% in July. In India the Sensex Index was able to tack on only slightly more than a point as earnings generally missed estimates.
Commodities – one of the hallmark risk trades – soared with the nearly +7.0% gain in the DJ UBS Commodity Index being driven not only by the +4.4% rise in oil but an even larger percentage increase in industrial metals. Oil prices were driven higher by evidence that global demand remains strong and the expectation that inventories will decline.
With inflation absolutely nowhere to be seen, the Fed was free to keep its foot firmly on the gas pedal. Indeed, there were even rumblings in July coming out of the central bank that deflation was beginning to become a concern. The yield on the two-year Treasury note – which reacts directly to expected changes in monetary policy – fell to a record low of 0.55% while further out on the yield curve the 10-year note spent most of the month below 3%. Talk in monetary policy circles has now turned to additional quantitative easing. Record low interest rates are driving a surge of corporate bond issuance as finance chiefs take advantage of super low borrowing costs. U.S. corporate issuance was $85.7 in July, a 30% increase from June issuance levels.
Also pushing rates lower is economic growth that can only be described as anemic. Second quarter GDP grew at only a +2.4% annual rate, down from +3.7% in the first three months of the year. The story remains the same. Consumers are not spending, employment growth is nonexistent and the housing market has essentially come to a halt with the expiration of the government’s homebuyer incentives. Adding to the economic drag is the fact that the trade deficit has started to expand, increasing nearly $100 billion in the second quarter alone. Disposable personal income growth is actually pretty good, growing at a +4.4% annual rate in the second quarter. The problem is that personal spending is not. Spending grew only +1.4% during the quarter, which is a substantial deceleration from the nearly +4.0% pace seen in the first three months of the year. Retail sales remain weak.
Still, we do not see a double dip. Growth in the global economy will keep GDP in the U.S. from turning negative. But the tug of war we outlined at the beginning of this commentary remains in place. Earnings and valuations will drive stock prices higher when macro concerns recede to the background. When July’s rally tires, as we think it will, the glum state of the U.S. economy will drive prices lower. Thus, the market is likely to remain range bound with 1150 on the S&P 500 on the upside and 1050 on the downside.
David C. Reilly, CFA
Decision Critical ResourcesAugust 2, 2010In the struggle between gangbuster earnings growth and attractive valuations on one side and scary macro trends on the other, the bulls won out in July as stocks soared past worries about global debt levels, shell shocked consumers, a housing market that has fallen off a cliff and slowing exports.On a total return basis, both the Dow and the S&P rose more than 7% while the Nasdaq Composite was close behind with a gain of +6.9%. As the month progressed deeper into earnings season, it became clear that the brutal, multi-year effort to cut operating costs continues to pay dividends. Seventy five percent of reporting companies are beating admittedly pared back earnings estimates and, despite worries about paltry top-line growth, two-thirds are exceeding revenue estimates as well. Moreover, earnings are coming in approximately 11% over consensus expectations, a margin well over what we have seen in recent quarters. July’s rally put year-to-date performance for the Dow into the black with a gain of nearly +2.0% while the broader S&P 500 had nearly wiped out earlier losses.July’s rally brought visible evidence that the risk trade was back on – at least for now. Mid and small cap stocks essentially matched the gains of their larger counterparts as shown by the +6.9% jump in the S&P 400 Midcap and Russell 2000 small cap indexes. At the sector level, the global growth trade (energy, materials and industrials) lead the way higher with index-level gains ranging from +12.2% for materials stocks to +8.8% for energy stocks.International stocks rebounded strongly with the benchmark MSCI EAFE Index gaining +9.5%. Although European markets rose, they generally lagged returns in the U.S. due to slower growth prospects, massive debt overhangs and fiscal belt tightening. Despite the headwinds, there was palpable relief that the vast majority of European banks passed their stress tests even if there were rumblings that the criteria were not as stringent as they could be. Sentiment turned up – particularly among business – and was aided, no doubt, by successful bond issuances by Portugal and Spain.Emerging markets, on the other hand, generally beat returns seen in the U.S. with a gain of over +8.0% for the MSCI EM Index. EM returns were, however, uneven. Chinese stocks emerged from their long downswing as the country appears to have engineered a slowdown in runaway growth and achieved the much hoped for soft landing. This drove the Shanghai Composite up over +10%. Among the BRICS, this performance was exceeded only by Brazil, which rode the back of a powerful boom in commodity prices. The Bovespa Index rose +10.8% in July. In India the Sensex Index was able to tack on only slightly more than a point as earnings generally missed estimates.Commodities – one of the hallmark risk trades – soared with the nearly +7.0% gain in the DJ UBS Commodity Index being driven not only by the +4.4% rise in oil but an even larger percentage increase in industrial metals. Oil prices were driven higher by evidence that global demand remains strong and the expectation that inventories will decline.With inflation absolutely nowhere to be seen, the Fed was free to keep its foot firmly on the gas pedal. Indeed, there were even rumblings in July coming out of the central bank that deflation was beginning to become a concern. The yield on the two-year Treasury note – which reacts directly to expected changes in monetary policy – fell to a record low of 0.55% while further out on the yield curve the 10-year note spent most of the month below 3%. Talk in monetary policy circles has now turned to additional quantitative easing. Record low interest rates are driving a surge of corporate bond issuance as finance chiefs take advantage of super low borrowing costs. U.S. corporate issuance was $85.7 in July, a 30% increase from June issuance levels.Also pushing rates lower is economic growth that can only be described as anemic. Second quarter GDP grew at only a +2.4% annual rate, down from +3.7% in the first three months of the year. The story remains the same. Consumers are not spending, employment growth is nonexistent and the housing market has essentially come to a halt with the expiration of the government’s homebuyer incentives. Adding to the economic drag is the fact that the trade deficit has started to expand, increasing nearly $100 billion in the second quarter alone. Disposable personal income growth is actually pretty good, growing at a +4.4% annual rate in the second quarter. The problem is that personal spending is not. Spending grew only +1.4% during the quarter, which is a substantial deceleration from the nearly +4.0% pace seen in the first three months of the year. Retail sales remain weak.Still, we do not see a double dip. Growth in the global economy will keep GDP in the U.S. from turning negative. But the tug of war we outlined at the beginning of this commentary remains in place. Earnings and valuations will drive stock prices higher when macro concerns recede to the background. When July’s rally tires, as we think it will, the glum state of the U.S. economy will drive prices lower. Thus, the market is likely to remain range bound with 1150 on the S&P 500 on the upside and 1050 on the downside.
David C. Reilly, CFA
