Market and Economic Comments
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The bull market, which began in March of 2009, continued in the second quarter of 2010 as stocks pushed to new recovery highs in the opening weeks of April. Stocks marched higher as they correctly anticipated robust first quarter earning reports. Companies in the S&P 500 grew earnings 52% versus the first quarter of 2009, while earnings for the companies in the Russell 2000 Growth expanded by an amazing 99% versus the first quarter of 2009. Additionally, strong corporate guidance and favorable economic conditions led analysts to increase their forward earnings estimates. However, with the S&P 500 up nearly 80% in less than 14 months, the market was due for a short-term correction.
Volatility increased in the second half of the quarter as the market corrected and several uncertainties emerged. The first uncertainty emerged on April 20th, when a tragic explosion occurred on the Deepwater Horizon oil drilling rig in the Gulf of Mexico. When the rig sank two days later, oil began to leak from BP’s Macondo well a mile under the ocean’s surface, creating one of the largest environmental disasters in history. With possible broad implications on multiple industries such as new regulations for energy companies or weak demand for travel related industries in the Gulf region, the stock market reacted poorly to the constant stream of negative news from the disaster. On May 6th, investor nerves were jolted when the markets experienced the intraday “Flash Crash”. During 15 minutes of trading, most major indexes plunged roughly 7% before partially rebounding later the same day. While the cause is still being studied, it appears that a short-term drop in liquidity and poor coordination between major stock exchanges is to blame. Lastly, the debate over financial regulatory reform intensified during the quarter. Stocks in the important financial sector struggled as various portions of the bill were debated.
In the next few months, we expect partial resolution to most of these uncertainties, which will allow the market to resume climbing “the wall of worry”. First, while agonizingly slow, BP continues to make progress on containing the oil leak and they expect to complete the first of two relief wells in August. Even though cleanup efforts are likely to take many years, news from the disaster will be less impactful on the stock market following containment of the leak. Second, to prevent another Flash Crash, the SEC has begun testing circuit breakers on individual stocks. Additional jolts to the market are less likely as these new circuit breakers and other procedural changes are implemented. Lastly, the completion of financial reform in the third quarter will remove a major uncertainty plaguing the stocks in the financial sector.
The U.S. economy continues to gradually recover. The most recent report stated first quarter GDP grew a respectable 2.7%, which was led by the manufacturing sector. Manufacturing continued to expand strongly in the second quarter. Recent indicators, such as the ISM Index, have implied only a slight cooling to the white-hot pace of the last few quarters. News from housing and employment trends has been mixed. Home sales reports have been volatile from month to month due to the timing of government incentives, with overall trends well below historical levels. With no near-term threat of inflation, mortgage rates have reached multi-decade lows and should eventually stimulate purchase activity. Unfortunately, employment has lived up to its reputation as a lagging economic indicator. Despite improving demand, corporate profitability and balance sheets, job creation has been sluggish, with the unemployment rate stubbornly high at 9.5% in June. As the economy improves further, businesses will be forced to hire to meet demand. As of July 1st, the economists who participate in the Blue Chip Financial Forecasts believe the U.S. economy will grow at a steady 2.9 to 3.1% pace in each of the next six quarters. At this growth rate, job creation is inevitable.
The economic recovery also continues outside of the U.S. Canada, the U.S.’s largest trading partner, reported 6.1% GDP growth in the first quarter. This is the fastest growth of Canada’s economy in over 10 years. Europe has remained stable despite the debt concerns we discussed in the April letter. On May 9th, the member states of the EU announced the European Financial Stability Facility. This facility has the ability to lend nearly $1 trillion to Eurozone states in difficulty. The Euro has stabilized since this announcement, which should give these economies time to take needed budget deficit and debt reduction actions. China’s economy surged at an 11.9% annual pace in the first quarter of 2010. The Chinese government continues to take action to cool the economy, with the goal of reaching a more sustainable 8-9% GDP growth rate. Key among these initiatives was the June 20th announcement by China’s central bank to allow the country’s currency to float more freely against the dollar and other currencies.
The outlook for stocks is bright. Valuations suggest the recent correction is nearing its completion. The 2011 PE ratio on the S&P 500 stood at 11.1 on June 30th, which is well below the long term average of 15. Meanwhile, corporate earnings growth is expected to continue at a robust pace. On average, analysts expect S&P 500 earnings to grow by 22% in 2010 and 16% in 2011. Earnings for the smaller companies in the Russell 2000 Growth index are expected to grow by an impressive 57% in 2010 and 44% in 2011. Cheap valuations during a period of low interest rates and rapid corporate earnings growth is unusual and has created an excellent buying opportunity for investors.
We continue to be optimistic. Historically, a stable or improving economy, strong corporate earnings growth, and reasonable valuations have been excellent predictors of significant outperformance for Insight’s portfolios. We believe that Insight’s investment process is poised to deliver the returns you have come to expect from us. We look forward to reporting back to you in October.
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July 29, 2010
Stocks found support after another round of upbeat earnings and reassuring words from Federal Reserve Chairman Ben Bernanke. The Nasdaq Composite soared 4.2% for the week, while the S&P 500 jumped 3.6% and the Dow Jones Industrial Average added 3.2%.