Instead of going through today’s news, I thought I would provide a short review of the mid-year market performance.
The S&P 500 finished the first half of the year up 5.0% (see chart below). The year was full of macro events that have impacted both the market and the economy. 2011 started with an unusual bevy of major events, including natural disasters, war, inflation, quantitative easing, food riots, civil wars, and near-sovereign debt defaults. Probably the biggest two events impacting the markets were the earthquake and resulting tsunami in Japan, which occurred in early March, and the continuing saga of Greece. The earthquake/tsunami impacted supply chain logistics in many industries, most notably in electronics and the auto industry. Additionally, weaker than expected demand from Japan, as well as a major shift in spending towards clean-up efforts have impacted a number of companies and industries. The Greek issues are eerily similar to the state budget crises in the US as the government is caught between the needs of creditors, public unions, taxpayers, and those requiring state assistance. It’s a tricky balancing act, and while I always think I could do a better job than the guy in office, I’m glad I’m not that guy today.
The top performing sector in the S&P was the long dormant Health Care, rising 12.7%. Health Care is typically a defensive sector, and started its run of outperformance around late February as concerns about the strength of the recovery became prominent. This was also the time when economic data began deteriorating. Health Care struggled in 2010, primarily due to concerns about the impact of the Health Care reform package passed in the spring of 2010.
Energy (see chart below) was the second best performing sector. Fed quantitative easing, incremental demand from emerging market economies, and a tight supply/demand relationship helped push oil prices (WTI) up from $94 at the beginning of the year to almost $115 by the end of April. The price of WTI is now back to $94, where it began the year. Additionally, US natural gas drilling has accelerated this year as state’s have begun making their gas reserves more accessible by allowing a drilling method known as hydraulic fracture, or fracking. The increase in supply has had dramatic impacts on the energy market. First, natural gas prices in the US have stayed low, and are still 68% from their July 2008 highs. Second, in the state of Pennsylvania alone, fracking is responsible for adding 28K mining and drilling jobs. Other states are taking notice as New York announced this morning that they would begin allowing fracking as well. LNG terminals built over the past decade to import massive amounts of liquid natural gas now sit idle while companies scramble to build more natural gas pipelines. If the discoveries are as large as experts are estimating, natural gas has the potential to become a true base fuel in the US (along with oil and coal).
Consumer Discretionary was the third best performing sector in the S&P 500, rising 8.1% in the first half of the year. The combination of Health Care, Energy and Consumer Discretionary is an unusual one as typically Health Care outperforms as the economy slows, energy in the mid-late portion of an economic cycle, and Consumer Discretionary in the early to mid-portion of the cycle. Consumer stocks did well because of their moderate valuations, a small uptick in consumer spending, and a consolidation over the past three years which lowered the total number of stores in the US. Additionally, take out activity has been very robust in the retail space as private equity firms have been taking advantage of the attractive valuations.
The worst performing group in the S&P 500 was the Financials (see chart below), which declined 3.7% and was the only sector down for the first half of the year. After rising from the start of QE2 in November until mid-February, financials suffered for the next four months as the weak fundamentals of their business began to overtake the benefits of cheap Fed funding. Balance sheets are moderately better than they were two years ago, but there are still billions of dollars of non-performing and under-performing loans on the balance sheets of banks. They are slowly cleaning up their balance sheets, but there is no incentive to do it quickly because there really isn’t a market for many of the assets. Additionally, the pending implementation of Dodd-Frank will add layers of costs to banks as they attempt to comply with the new regulations, and will also limit some of their ability to generate income.
2nd Half 2011
There are a couple of key items to watch in the 2nd half of 2011. First, what will be the impact of the official end of QE-2? My thought is that treasury yields will gradually move to a higher level, but that the bottom won’t fall out of the treasury market. Offsetting the lower demand for treasuries resulting from the official end of QE-2 will be an increase in demand from investors as the economy continues to moderate.
Employment is the biggest factor holding back the US recovery, and unfortunately I don’t see any marked improvement for the 2nd half of 2011. Taking a page from the playbook of the Great Depression, the Fed has attempted to inflate prices in an effort to drive wages up. In my view there are two significant differences that will limit the effectiveness of this tactic. First, there hasn’t been enough production capacity taken offline in the US. In 1939, over 35% of production capacity had been eliminated during the prior decade, so when inflation and demand started there was a need to purchase capital equipment and quickly hire to meet demand, and wages began rising. Today we have only lost a mid-single digit level of capacity, so any increase in demand will be quickly filled by the excess capacity, and not necessarily require additional capital expenditures or hiring. The second difference is the mix of manufacturing employment in the US, which today sits at 12%. In 1939 manufacturing employment was around 50%. A pickup in demand for manufactured goods will benefit employment in countries and states that have competitive wage structures, not necessarily in the US.
After a nearly two month decline, the market was oversold as of last week. The market is not excessively valued, and I would expect it to continue to be a range-bound market with a slight upward bias unless there is another macro event or the economy slows down much harder than what we are seeing today.