Second Quarter 2011 Market Review - Late Quarter Rally Puts Stocks Back on Track

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 |  Includes: DIA, QQQ, SPY
by: John D. Frankola
The stock market, as measured by the S&P 500 Index, advanced 5.6% over the final four days of the quarter. Had the quarter ended a week earlier, the market’s first half returns would have been characterized as a disappointing 0.4% - a pace significantly below the almost 10% long-term average annual return for stocks. Conversely, the late quarter rally allowed the S&P 500 to end the first six months of 2011 with 6.0% total returns – putting stocks on target for another good year.
However, it is best not to read too much into the recent performance. By the time you actually read this, the market could be up or down another 5%. What the late quarter move should remind investors is that the stock market is volatile and unpredictable in the short-term. Not much really changed in the final week of the quarter. The Greek parliament approved another austerity program and European banks accepted a plan to roll over Greek debt. However, it’s hard to believe this event was the catalyst for adding almost $1 trillion of market value to the US stock market.
The following table shows stock market performance for various times periods.
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Continuing with the theme that the stock market is unpredictable in the short term, take a look at the one-year performance. The S&P 500 returns of 30.7% reflects a strong recovery from last summer’s correction, which was attributed to the Gulf Oil Spill, the May 6 flash crash (a 10% stock market drop during a 30-minute period), the European debt crisis and the first Greek bailout. These problems, combined with weak economic data, led many investors to sell stocks last summer, as they believed that the US was headed into a “double-dip” recession. The past 12-month rally off the lows of last summer seems to indicate that many investors over-reacted to negative news last year.

Data from the Investment Company Institute seems to document the tendency of short-term investors to sell at inopportune times. For example, in the three-week period ending June 22, 2011, investors took $17.1 billion out of equity funds. This was the largest amount of equity fund outflows since the month of August 2010, when $16.9 flowed out of equity funds as the market was making a bottom. Following both time frames, stocks recovered strongly.
While stock performance in the second quarter of 2011 was essentially flat, as indicated by the 0.1% returns of the S&P 500, wide divergences in investor sentiment were clearly visible. The S&P 500 reached a post-crash high on April 29, but then fell by 7.3% to its low point on June 15. Signs of speculation appeared in the hot IPO (initial public offering) market with LinkedIn and Pandora going public and with anticipated offerings from Facebook and Groupon. At the other extreme, risk adverse investors poured $46 billion into bond mutual funds during the quarter, despite interest rates offering historically low yields.
The current list of problems for the economy is long. The pace of the US economic recovery is slow. In the first quarter, GDP grew at just 1.9%. Unemployment remains stubbornly high at 9.1%. The housing market is still bouncing along the bottom. The Federal Reserve’s second program (QE2) to stimulate the economy by purchasing Treasury securities ended in June, which raises concern that interest rates will soon rise. Congress has not yet dealt with the federal budget deficit or the national debt ceiling. Many state and local governments are experiencing significant financial problems. While the Greek situation has been temporarily resolved, many worry also about Portugal, Ireland, and Spain. Conflicts and uprisings in Asia, the Middle East, and Africa contribute to a high level of political and economic uncertainty and volatility in the energy markets.
While it might not seem like the best scenario for owning stocks, US companies are actually thriving in the current environment. The combined earnings of S&P 500 companies are expected to reach record levels in 2011, increasing by approximately 15% over 2010. Valuations for US companies appear to be reasonable, with the S&P 500 trading at 13.3 times estimated earnings. In addition, companies have significantly improved their balance sheets and now hold record levels of cash. These factors should result in higher dividends, share buybacks, and acquisitions of other companies – which should benefit equity investors.
Fixed income investments performed strongly in the second quarter as interest rates declined. The BarCap Aggregate Bond Index, which measures the performance of the taxable bond market, generated 2.3% returns during the quarter. The BarCap Municipal Bond Index produced 3.9% returns. The yield on the benchmark 10-year Treasury bond declined from 3.45% to 3.16% during the quarter. The decline in US interest rates and strong relative performance for bonds was generally attributed to concerns over a slowing US economy and the European sovereign debt crisis. With the likelihood that interest rates will eventually move higher as the economy improves and/or inflation increases, longer-term bonds appear to be somewhat risky (since bond prices decline when interest rates rise).
The results of the past quarter seem to demonstrate that the investment community has considerable skepticism about the ability of the US economy to continue its recovery. Indeed, many of the current problems, such as those related to government deficits and unemployment, will likely take a long time to resolve. However, most corporations have adjusted their business models so that they are able to succeed in the current environment. In this regard, equity investments appear to be relatively attractive for investors with long-term horizons.

Disclaimer: The author is the president of Vista Investment Management, LLC, a Registered Investment Advisory firm. Under no circumstances does this article represent a recommendation to buy or sell stocks. This article is intended to provide information and analysis regarding investments and is not a solicitation of any kind. References to historical market data are intended for informational purposes; past performance cannot be considered a guarantee of future performance. Neither the author nor Vista Investment Management, LLC has undertaken any responsibility to update any portion of this article in response to events which may transpire subsequent to its original publication date.

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.