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Following four quarters of strong performance, the stock market fell sharply in the second quarter of 2010. After reaching a 19-month high on April 23, the S&P 500 Index declined by 15.4% to finish the quarter with an 11.4% loss. The other major stock market benchmarks experienced similar performances as summarized in the table below.

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There were a number of issues that spooked investors during the second quarter:
  • Greece required a bailout to avoid a default on its sovereign debt. Worries spread that other European countries, including Portugal and Spain would also require support. The Euro fell to its lowest level in years and concern mounted that Europe would soon lapse into recession. Some investors feared that a slumping Europe could drag the U.S. back into a recession as well.

  • On May 6 the U.S. stock market fell by almost 10% in the span of less than thirty minutes. By the end of the day, the market recovered most of its losses, but the episode was very damaging to investors’ confidence. The cause of the “flash crash” remains largely unexplained, despite a number of investigations. It is likely that high frequency traders – firms which buy and sell large volumes of securities to make just a fraction of a cent per share – contributed to the problem. It is the opinion of many that these traders have a very negative influence on market volatility. Yet at this point, there has been no effort to curtail this activity.

  • An explosion and fire on BP’s Deepwater Horizon drilling rig resulted in a loss of eleven lives and produced the largest oil spill in U.S. history. The spill has not only caused a significant disruption of the lives and economies of the Gulf region, but it has probably led to negative consumer and investor sentiment. In addition, the stock prices of many energy and oil service companies declined sharply.

  • The pace of the economic recovery showed some signs of slowing. The May and June employment reports indicated less than expected job growth in the private sector. May’s retail sales also disappointed.

  • Newly proposed financial regulations produced uncertainty for many financial service companies – and probably contributed to weaker stock prices. While most agree that better regulations and enforcement are needed, there is concern that the new regulations will lead to reduced lending and add additional layers to the regulatory bureaucracy.

  • Unfortunately, the decline in stock prices not only reflects negative developments, but also likely contributed to weakness in the economy. When asset values for stocks and homes decline (or appreciate) significantly, it produces a wealth effect. Individuals are less likely to spend when asset values are low and more likely to consume when values are high. In this digital age, investors are more sensitive than ever to changes in the value of their portfolios, since this information can be accessed on a real time basis. Considering the market’s correction in the second quarter, it is not surprising to see some weakness in retail sales numbers and other economic data, as investors react to a decline in their net worth.

  • While there has been a significant amount of bad news recently, on balance, the economy is still on the road to recovery. The savings rate in May was a very strong 4.0%. Credit card delinquencies fell to a 5-month low. In May, monthly railroad shipping volume grew by 15.8% and industrial production rose by 7.6 % compared to the previous year. For example, while the market reacted negatively when retail sales declined 1.2% from April to May, it is worth noting that May’s retail sales were up 6.9% compared to the previous year. Although companies are reluctant to add new employees, those with jobs are earning more and working longer hours. In May, personal income rose at a 4.8% annual rate, increasing for the seventh consecutive month. The Conference BoardEmployment Trends Index (ETI) rose by 0.5% in May to its highest level since December 2008. The index was up 8.9% from the previous year, its biggest 12-month gain since 1995.

  • While most economic trends have improved significantly since the fourth quarter of 2008 and the first quarter of 2009, the memories of that time frame have changed the behavior of many investors and corporations, much in the same way that the Depression effected those that lived during that era. This might be best demonstrated in the hoarding of cash and other investments that are perceived to be low risk. At the end of May, Americans held a record $5.1 trillion in savings accounts at banks and thrift institutions. Another $2.8 trillion was held in money market funds, which were earning an average interest rate of less than 0.1%. Money poured into Treasury securities, pushing yields to historically low levels. At the end of June, the yield on the benchmark 10-year Treasury bond was 2.96%, down from 3.84% at the end of the first quarter.

  • Companies stockpiled cash too. According to S&P, nonfinancial companies in the S&P 500 held a record $837 billion in cash at the end of the first quarter, up from $664 billion a year earlier. While companies made an effort to firm up their balance sheets, many also used some of the cash to enhance shareholder value. In the first six months of 2010 there were 135 dividend increases among companies in the S&P 500, up 55% from last year. According to Bank of America Merrill Lynch there were 343 authorizations for share repurchases totaling $178 billion in the first half of 2010, significantly more in value than all of 2009.

  • If the economic recovery continues and corporate profits expand, it is likely that a good amount of the cash held by both individual investors and companies will go into purchasing stocks. Corporations are likely to deploy cash by acquiring other companies as well as through additional share buy-backs. Although investors might feel safe with money in savings accounts or money market funds, it is not possible for most investors to achieve their long-term goals with returns of between 0% and 3%. At some point when perceived risk levels subside, investors will likely venture back into stocks.

  • Corporate profits are experiencing a strong recovery in 2010. Earnings of companies in the S&P 500 Index are collectively forecasted to increase over 40% in 2010 and approach record levels in 2011. Rising corporate earnings should lead to higher stock prices.

  • Considering the positive earnings outlook and the recent retreat in stock prices, the market looks to be undervalued. The S&P 500 Index currently trades at 12.0 times its next 12-month estimated earnings – the lowest level since the 1989.

While there are many problems currently facing the economy and stock market, this scenario is typical for the early stage of an economic expansion. Difficult problems are not easily resolved and there is usually fear that the economy will slip back into a recession. In addition, it is likely that market volatility will remain high in the short-term, pending the resolution of current concerns. However, these situations also present tremendous opportunities. Some of the strongest bull markets have followed periods of difficulty, when expectations were low. With high levels of cash currently parked in low returning assets and equity valuations at historically low levels, the stock market has strong upside potential if the economic recovery stays on course.

Disclosure: No holdings in companies mentioned.
Source: Q2 2010 Market Review: Strong Upside Potential