Stock markets produced positive gains in the second quarter of 2009. The S&P 500 Index generated returns of 15.9% for the quarter as investors’ confidence improved with signs that the economy may be turning around. While most economic data continued to show significant weakness, the rate of economic contraction has slowed, and some indicators have begun to turn positive. In particular, the Index of Leading Economic Indicators, which weighs ten forward-looking statistics, increased sharply in April and May. There are even signs that the housing market may be improving, with the Pending Home Sales Index rising for four consecutive months. Credit markets are functioning almost normally again as creditworthy companies are now able to borrow at reasonable rates. In addition, the banking sector, while not fully recovered, has improved significantly. In March, some worried that the entire banking sector was insolvent and facing nationalization; by June, many banks were repaying their TARP loans, once again on firm financial footing.
During the second quarter interest rates on Treasury securities rose, partially due to the significant issuance of new debt by the federal government, but also because other investments became relatively more attractive as investors become more risk tolerant. The yield on the 10-year Treasury bond rose from 2.60% to 3.52% during the quarter. The LB Aggregate Bond Index – a broad measure of the entire bond market - produced total returns of 1.78% for the second quarter.
While it is possible to cite many individual signs of improvement, perhaps the most important factor contributing to the strong stock market performance in the second quarter was the general improvement in consumer and investor psychology. For much of the previous six months, fears of another great depression weighed on the collective public consciousness. Although the current recession will be remembered for its length and severity, the possibility of another great depression seems to have faded. The University of Michigan Consumer Sentiment Index has shown three consecutive months of improvement, reflecting this positive change in attitude.
With the depression scenario fading away, one of the most significant trends of the second quarter was the shift of funds from lower-risk assets to higher-risk assets. Small companies outperformed large companies; emerging markets dramatically outpaced developed markets; and junk bonds recovered in price while longer-term Treasury securities produced losses. If the economy continues to recover, this trend is likely to continue for some time.
At the end of the quarter, the S&P Index stood at 919, which was 35.9% above its bottom of 677 (March 9, 2009), but still 41.3% below the all-time high of 1565 (October 9, 2007).
The market’s 35.9% gain from the bottom reflects the improving fundamentals discussed above. But trading at a level 41.3% below its peak seems to indicate that investors still have significant concerns that a recovery will materialize. Unemployment continues to rise, businesses struggle with losses and solvency (GM and Chrysler both entered bankruptcy), banks expect more bad debt problems related to commercial real estate and credit cards, states and municipalities are running out of money, and the federal government is generating a massive budget deficit and is issuing debt at an alarming rate.
So while it looks like the worse case – a depression – is no longer a major worry, the stock market will need to see further improvement in economic conditions and corporate earnings for it to move higher. In all likelihood, there will be a number of mixed signals, which will produce market volatility in the short term. However, with credit markets now functioning in a more normal manner, emerging markets (China in particular) starting to rebound, stimulus spending kicking in and consumer confidence strengthening, the U.S. economy should show more signs of improvement in the second half of the year.
Looking beyond the near-term uncertainty, stocks appear to have very good return potential for long-term investors. First, lower stock prices have made stocks cheap based on traditional measures of value. As an example, S&P Equity research notes that the S&P 500 currently has an average price-to-book value ratio of 1.3. Its average over the past 22 years has been 2.2. This ratio has not been this low since the bear market of 1990, which preceded a nine-year bull market.
Although the recession and stock market correction have been very painful for most Americans, the lessons learned from the current situation should result in better future behavior by businesses and consumers. Banks will be more careful when lending money and making investments. Consumers are likely to be more prudent in their spending. Already a significant change in consumer behavior is evident. The U.S. saving rate was close to zero in the first quarter of 2008 - it is now at 6.9%. While this has temporarily hurt economic growth, the long-term benefits will be a stronger consumer and a more stable economy. In all likelihood, a sustained economic expansion should lead to an eventual recovery in asset values.