No doubt about it, September was a rough month in the markets.
China admitted that their economic growth rate was slowing due to reduced exports. Europe was a key source of angst as questions arose about the soundness of French & German banks. On days when fears were put at bay the market saw 2-3% gains, but when new fears arose stocks declined 3-4% over a very broad base. This series of ups & downs netted out at a 7.2% decline for the S&P 500 last month.
Index Sept 2011 YTD 2011
During the month we observed a few positive key US economic data points. Second quarter GDP was revised upward from 1.0% to 1.3%, new jobless claims returned to April lows, and the monthly inflation rate was near zero. The University of Michigan index of consumer expectations, core capital goods shipments and the Chicago Purchasing Managers Index ticked up also, exceeding estimates. Oil ended the month at its lowest point for the year, easing its drag on corporate profits and consumer spending.
It is rarer than a “blue moon” when the average stock yields more than ten year US Government Treasury bonds. Only 20 times since 1953 has this occurred at the end of a quarter, and the end of September was one of those rare periods, with the average equity yielding 2.13% vs. 1.92% for the bonds. Federal Reserve purchases of longer dated Treasuries as short-term issues mature under “Operation Twist” could be partially responsible for this latest “blue moon.” Following such an event, historically the S&P 500 was up 80% of the time in the following twelve months, with an average gain 20%. (Source: Standard & Poor’s)
The market revisited its August lows several times last month and was able to successfully hold those levels. While the Europeans push through on banking and debt reform, we are encouraged by the major US monthly manufacturing surveys. Both the Philadelphia Federal Reserve and the broader Institute for Supply Management noted a pick-up in production and employment for the month. We continue to favor large cap, higher-quality issues with above-average dividend yields and exposure to developing markets.
Drastic and sudden events in late August at Hewlett Packard (NYSE: HPQ) ultimately changed our investment thesis on the stock. We waited until September 21, when the stock was up 10% on speculation of the CEO being ousted at their board meeting and used it as an opportunity to sell the shares. Our thought is that the challenges to HPQ run deeper than the CEO.
Walgreen (NYSE:WAG) has been under pressure due to uncertainty regarding negotiations with Express Scripts (NASDAQ:ESRX). Certainly Walgreen has never been engulfed in such a battle with a network provider, and a consolidating one at that. But management displayed strength in their negotiations with CVS last year, and we believe their exposure could be as little 4% of earnings while the market is discounting nearly a complete breakdown in contracts and a 20% hit to earnings. With valuation relative to the consumer staples sector at the bottom of its ten year range, we believe shares are inexpensive and used this as an opportunity to add to positions.
The US government issued its final report on the Deepwater Horizon oil spill in the Gulf of Mexico 17 months after the event. In it, British Petroleum (NYSE: BP) was assigned some---but not all---of the blame and some uncertainties around responsibility were removed. The report also had over 50 recommended changes to offshore drilling practices.
United Technologies (NYSE: UTX) is acquiring Goodrich Corp. (NYSE: GR) to augment its military and commercial aerospace businesses, adding $8 billion to UTX’s annual revenues of $58 billion. Goodrich has been growing more quickly than UTX’s Pratt & Whitney or Hamilton Sundstrand divisions, and carries higher profit margins than the UTX corporate average. Given the success of past acquisitions and the trajectory of the Goodrich business, we believe this is a good intermediate to long term decision for shareholders.
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