Third Quarter 2009 Market Review

 |  Includes: DIA, SPY
by: John D. Frankola

The market’s strong rally, which began in early March, continued through this year’s third quarter. The S&P 500 Index produced returns of 15.6% for the quarter, as more signs emerged that an economic recovery had begun. From its low on March 9, 2009, the S&P 500 has risen 56%. Even with this strong performance, the S&P 500 stands 7% below its year-ago level and 32% below its all-time high of October 9, 2007.

While the quarter and year-to-date numbers have been very strong, the following table illustrates that the major stock market indices continue to show 3, 5, and 10-year results that are significantly below the long-term annual average of almost 10%.

Equity Performance for Periods Ending on September 30, 2009

Total Returns

___ Annualized___
Market Year-
Index Sector Quarter to-date 1-Year 3-year 5-year 10-year
S&P 500 Large Company 15.6% 19.3% -6.9% -5.4% 1.0% -0.2%
Russell 2000 Small Company 19.3% 22.4% -9.6% -4.6% 2.4% 4.9%
MSCI EAFE International 18.7% 25.5% 0.0% -6.3% 3.3% 0.3%
Click to enlarge

Click to enlarge

Much has changed over the past twelve months

Last year, Congress, the Treasury Department and the Federal Reserve were working out details of a program to head off a collapse of the US financial system. Today, almost one third of the TARP funds used to infuse capital into the banking system have been repaid. The credit freeze that produced a virtual paralysis in commerce has largely thawed. According to Dealogic, so far this year, corporations have issued $700 billion in new debt, an increase of more than 38% over last year. Last year’s fourth quarter produced a precipitous drop in virtually all economic indicators. This past September, the Conference Board reported that the Index of Leading Economic Indicators increased for the fifth consecutive month. This streak followed 20 consecutive months of declines.

The economy appears to be recovering, but there are still a number of concerns

There are a number of other positive factors which signal that the economy will continue to strengthen. First of all, the recession is probably over (as indicated by Fed Chairman Ben Bernanke on September 16), although an official declaration of this occurrence will not happen for some time. As noted above, a number of leading indicators have turned positive, the housing industry has stabilized, retails sales are improving, and the manufacturing sector is strengthening. In addition, low energy prices, low inflation, and low interest rates should continue to support a recovering economy. Finally, forecasted growth in emerging markets like China, India, and Brazil should help to sustain a global economic recovery.

Of course, all is not yet rosy. While the economy is improving, it remains weak. The most bothersome statistic relates to unemployment, which stands at 9.8%, the highest level in 26 years. Unemployment is a lagging statistic – it is one of the last to show improvement, since companies will add overtime before they hire new employees. Consumer debt remains high, which could also limit an economic expansion. There is also uneasiness about the government’s larger role in the economy. Stimulus spending, corporate bailouts, large ownership stakes in many U.S. corporations, proposed healthcare reform, expected tax increases, and large projected budget deficits are all significant concerns for investors.

Interest rates remain low

Interest rates declined during the quarter, which helped to generate returns of 3.8% for LB Aggregate Bond Index (bond prices rise when interest rates fall). The yield on the benchmark 10-year Treasury note fell to 3.31% from 3.52% at the end of June. Prices of Treasury and mortgage-backed securities were supported by purchases by the Federal Reserve, in an effort to keep interest rates low. Corporate bond prices also increased as companies made efforts to strengthen their balance sheets and an improving economy reduced the risk of default. With interest rates near historic low levels, long-term bonds appear to be somewhat risky, since an increase in interest rates will force bond prices lower.

Looking forward

The current consensus is that the economy will continue to improve, but that growth will be less than robust. Some worry that the U.S. could fall back into recession once the stimulus dollars are spent. Most expect unemployment to recover very slowly. While this might seem like a weak backdrop for positive stock market performance, corporate earnings could recover strongly even if economic growth is lackluster. Over the next several quarters, corporate earnings will appear to be very strong when compared to the depressed levels of the previous year. Also, corporate cost cutting over the past year has positioned U.S. companies for strong earnings growth, with just a modest increase in revenues. As business confidence improves and more credit is available, merger and acquisition activity is also likely to put upward pressure on stock prices. Finally, there is a considerable amount of money on the sidelines, with money market funds currently holding $3.4 billion. As investor confidence improves, some of this money (which is earning less than 1%) could find its way into stocks.