Stocks took a bit of a breather in May as the S&P 500 index declined 1.13% for the Month. Year-to-date stock performance has still been solid with a gain of 7.82% including dividends. Bonds performed very well as we saw yields decline and prices rise due to growing sovereign debt concerns in the European Union.

 

A consensus of economic analysts expected 1^st quarter economic growth to be revised up to 2.2% but instead the final reading was left unchanged at 1.8%. This was a disappointment but the data hints that a good part of the slow growth is attributable to the earthquake/ tsunami / nuclear meltdown in Japan which created very significant supply chain disruptions that led to lower economic activity. These disruptions continued into the 2nd quarter so it is likely we will see disappointing growth continue a little longer.

 

Economic reports over the past couple of weeks confirm that the economy is still struggling with slow growth. The four week moving average of unemployment claims increased this past week to 439,000. Manufacturing production has slowed recently based on multiple reports including the ISM, Empire State index and the Philly Fed index. Despite a housing market that has already been struggling for a long time, housing starts fell steeply again in April. In addition, recent reports show a noticeable drop in auto sales and durable goods orders.

 

Slower economic growth did not interrupt the very favorable trend in corporate earnings growth. Based on corporate earnings reports released for the first quarter, in aggregate S&P 500 companies showed an increase of over 19% versus Q1 2010. This result is much stronger than was anticipated at the start of earnings season. S&P 500 Corporations now forecast full year earnings at $99.83 for 2011. Strong earnings are being driven by expanding profit margins and only modest revenue growth.

 

Core inflation is still contained but inflation concerns are beginning to heat up again as very modest preliminary signals point to the possibility of inflation picking up in coming months. It is likely too early to make this a primary concern at this point as other concerns are more imminent.

 

One of the most prevalent concerns is the sovereign debt issue throughout the developed world and particularly in Europe. European Union nations have been grappling about what to do with the debt of several countries that are essentially on the verge of default. Greece, Portugal and Ireland all have acute debt concerns that will need to be addressed very soon. Spain and Italy are much larger economies that will need to be addressed in the not too distant future. There is a very strong tendency among politicians to “kick the can down the road” because any solution will involve pain. The longer it takes to address these problems, though, the greater the pain will ultimately be. One thing we know for sure is that the problems will not resolve themselves without intervention.

 

This combination of a strong earnings environment in the midst of a modest recovery with the backdrop of a global economic minefield has led to strength in both stocks and bonds. This environment may well persist for a while longer but ultimately the status quo will change and we would expect an increased level of volatility to follow. In the meantime equity valuations remain attractive and bonds are serving their purpose as a safe haven. Please feel free to contact us with any questions or concerns you may have.

 

 

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