Q3 Market Review: High Volatility Continues

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Includes: DIA, JNJ, MSFT, QQQ, SPY
by: John D. Frankola

As has been the trend in 2010, stocks continued to display a high degree of volatility during the third quarter. After rallying 7.0% in July, then falling 4.5% in August, the S&P 500 Index had its best September since 1939, advancing by 8.9%. Ironically, on average, September has been the worst month of the year for stocks. According to the Stock Trader’s Almanac, since 1950, the S&P 500 Index has declined by an average of 0.7% during September. The strong September performance helped to push the year-to-date returns into positive territory, albeit, a modest 3.9%. For the third quarter, the S&P 500 Index generated total returns of 11.3%.

The performance of several major indices over various times frames is summarized below.

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The recent strong stock market performance could be attributed to several factors. Fears of a double-dip recession have seemed to subside. While economic growth in the U.S. and most of Europe is still very weak, the major economic indicators still point to a continued slow recovery.

The stock market has favorably viewed the prospect that Republicans will make significant gains in Congress in the November elections. In general, investors have regarded Democratic-initiated healthcare reform and financial service regulations as negative for businesses. Also, most investors clearly favor the Republican Party’s position on extending the Bush tax cuts related to dividends and capital gains.

The Federal Reserve has indicated that is prepared to take further steps to stimulate the economy. In September, Fed Chairman Ben Bernanke stated the “Fed is prepared to provide additional accommodation if needed.”

Corporate profits continue to recover strongly, helped considerably by cost cutting and growth in emerging markets. While S&P 500 profits are still below peak levels, Barron’s reported that corporate profits as a percentage of GDP are near a 40-year high. These earnings have pushed corporate cash balances to record levels. The Wall Street Journal reported that current cash balances of companies in the S&P 500 Index equals a record 11.6% of those companies’ market value, about twice the level for the period 1980 to 2007. This cash can be used enhance shareholder value by paying dividends, buying back shares, or making acquisitions.

While the recent advance in stock prices is welcome, there are still many concerns facing the market. On the economic front, the unemployment rate remains stubbornly high at 9.6%, which appears to be limiting the rebound in consumer spending. Major domestic industries, such as automotive and housing, remain at depressed levels. Many governments around the world face large budget deficits and mounting debt burdens. In addition, there is considerable uncertainty regarding new regulations and future tax policy in the U.S.

Over the past several years, many investors seem to have lost confidence in stocks as a long-term investment vehicle. At the same time, they have poured large sums of money into bonds, which they view as a low-risk asset class. This sentiment is perhaps best reflected in the mutual fund flows over the past two years. According to the Investment Company Institute, since the beginning of 2009, investors have withdrawn $100 billion from U.S. stock funds. Over the same period they have added $620 billion to bond funds. The trend has been just as strong in recent months, with investors pulling $27 billion from stock funds in July and August, while adding $61 billion to bonds funds during the same period.

The demand for bonds as a safe haven has helped to push interest rates to record low levels. The yield on the benchmark 10-year Treasury bond fell to 2.52% from 2.95% at the end of June. Many corporations attempted to take advantage of investors’ love affair with bonds by issuing new debt at record low interest rates. In August, Johnson & Johnson sold 10-year bonds with an interest rate of 2.95% - setting a record for the lowest interest rate for 10-year corporate bonds. Amazingly, at the time of issuance, Johnson & Johnson’s stock had a yield of 3.7%. In September, Microsoft set the record for the lowest rates on 5-year and 3-year corporate bonds, with yields of 1.625% and 0.875%, respectively. At the time of issuance, Microsoft’s stock had a yield of 2.6%. It almost appears irrational, that investors would choose lower-yielding bonds over stocks in these two instances.

While overall stock market sentiment is still largely negative, and many problems still need to be resolved, there remains considerable room for optimism. Many of the factors that are causing slow growth in the short term will ultimately produce a more stable economy over the long haul. For example, consumer credit fell in July at a 1.8% annual rate; it was the 20th decline in the past 22 months. This trend reflects both that banks have raised their lending standards and consumers are cleaning up their balance sheets. Lower consumer borrowing means less consumer spending now and slower growth, but it should result in a stronger economy in the future.

On September 20, the National Bureau of Economic Research (NBER) declared the recession that began in December 2007 ended in June 2009. The Great Recession, as many have called it, lasted 18 months, which made it the longest since World War II, and much longer than the average length of 11 months. Considering it took economists 15 months of historical data to determine when the recession ended, it points to the obvious difficulty in forecasting how long the current expansion might last. However, if history is any indicator, the economy is likely in the early stages of a multi-year expansion. Since 1945, the average economic expansion had a duration of 59 months.

Disclosure: Long JNJ and MSFT in portfolios managed by author.