Q1 2010 Market Commentary

 Market Summary

March 31, 2010 

Equities

The stock market returned to rally mode during the first quarter, after enduring a steep correction in February, fueled by ongoing global economic and political uncertainty surrounding the Greek credit crisis and healthcare reform.  Catalysts for the positive price action were better than expected corporate profits and economic data that continued to suggest the economy is on the mend.  The S&P 500 gained 54 points, or 5.39% during the quarter, to 1,169, marking its strongest first quarter since 1998.  In the quarter, value outperformed growth and shares of small companies outperformed those of large companies.
 

Following are some highlights from the 1^st Quarter:

Sovereign Debt – Fears of default in several nations, particularly Greece, sparked a sharp selloff in equities in February.  These fears abated when the European Union vowed to lend a hand, but this crisis continues to weigh on equities.  The S&P 500 dropped 10% in a few weeks after this news broke, but has since recovered and ascended to new year-to-date highs.

Dollar –The dollar has been a direct beneficiary of the euro area turbulence.  After declining the majority of last year, the dollar revived in the first quarter.  Investors bought the greenback as a safe haven amid the turmoil.  In addition, a growing number of analysts expect the Federal Reserve to begin raising interest rates from historic lows near 0% which would further underpin the dollar.

Unemployment – The unemployment rate fell to 9.7% in the quarter, down from 10.2% last year.  Although this moderation in the rate is a positive sign, unemployment remains near record highs.  The economy cannot fully recover without full participation of consumers and that, in turn, cannot occur without a meaningful improvement in employment. Labor market trends continue to hold an important key to the economic outlook.  A vigorous revival in job growth will be needed to sustain a strong recovery.

Housing Market – The government has been aggressively trying to stabilize housing prices.  In March, for the first time in over a year, housing prices stabilized month-over-month.  We are concerned that further deterioration may occur when the government decides to end its programs and tax rebates.  New homebuyers have been scrambling to take advantage of the $8,000 tax credit for first time home buyers.  Any decline in the housing market could place renewed pressure on the economy.

GDP – Gross domestic product, a basic measure of a country’s overall economic output, has been positive for the past two quarters, signaling an improvement in the economy.  Five of the previous six quarters had shown a negative growth rate.  This is an important figure to watch as it is often positively correlated with the standard of living.

Oil - The price of oil continued to grind higher as the prospects for a global economic recovery increased.  Oil finished the quarter at $83/barrel, up $4, or 5%, but still well below its all time high above $148/barrel in the summer of 2008.  The price of oil has been a delicate balancing act, as the price needs to be high enough to spur economic activity, but not too high where it puts a strain on already cash strapped consumers.

Health Care – Stealing much of the spotlight for the quarter were not the financial markets, but the historic passage of the $940 billion Health Care Reform Act.  There has been much skepticism among individuals and politicians alike concerning the details of the Act.  Most importantly, its massive price tag and the potential impact of the front-loaded spending on an already bloated deficit.

Fixed Income

Credit markets surged in the quarter, despite concerns over rising interest rates and the health of the economy.  High yield and corporate bonds outperformed Treasuries as yield seeking investors shunned their paltry yields.  The yield on the benchmark ten-year Treasury was 3.85% at the end of the quarter, virtually unchanged from the beginning of the year.  As previously stated, we continue to recommend shortened maturities for fixed income instruments due to the inflationary implications of all the stimulus provided by the Federal Reserve and Congress over the last 12-18 months.

What to expect for the rest of the year

The U.S. recession purportedly ended nine months ago, yet the economic environment still feels very vulnerable and fragile.  Although massive policy stimulus broke the downward spiral in asset values and economic activity, it has yet to trigger a self-sustaining and strong recovery in confidence and spending.  The easy money provided a powerful shot in the arm to the equity and bond markets, but the ongoing profound weakness in money and credit trends signals that deleveraging remains a major headwind for the economy.  Furthermore, the speed and severity of the economic and financial meltdown was extraordinary and is bound to have lingering effects.

With that being said, once a recovery begins, historical precedent demonstrates it tends to continue.   We continue to view the current environment of moderate economic growth, low inflation and extreme policy stimulus as very supportive of stock prices.  This should continue to be the case during the remainder of the year, although price gains are likely to be modest by the standards of the last year.

A year ago, valuations in the equity and corporate bond markets were very attractive, and policy reflation began to have a potent impact.  Currently, however, valuations are at best neutral, and the impact of stimulus has waned.  Nonetheless, it is still too soon to retreat into a defensive investment strategy as risk assets should continue to outperform the meager returns on offer from cash and government bonds during the remainder of the year.