The third quarter began fairly quietly, however events in July and early August contributed to significant declines in the global equity markets for the quarter. The S&P 500 declined about 14% during the three-month period, its weakest quarter since the fourth quarter of 2008. Global indices posted even more significant declines. In fact, on a global basis US large cap stocks were one of the strongest relative performers. The MSCI World Index fell 16.52%, while MSCI Emerging Markets declined 22.46%. The MSCI All Country World Index, which combines returns of MSCI Developed and Emerging Markets indices, was down 17.33%.

 

A steady stream of negative news contributed to the markets’ decline. The downward revisions in US GDP figures for Q1-2011 and prior periods signaled that economic growth in the current recovery was not as strong as previously assumed. Consistently disappointing employment reports, which began in June, cast further doubt on the strength of the US recovery. And, the highly contentious US debt ceiling debate struck a blow to global business confidence.

 

Coming on the heels of the debt ceiling controversy, Standard & Poor’s downgrade of US debt on August 5 reinforced the severe decline in global equity prices in early August. Ironically, affected US Treasury debt soared in price, sending yields tumbling. While these events played out in the US, solvency concerns in the eurozone intensified, and yields on Greek, Portuguese, Italian, Spanish and other government bonds rose sharply. A clear resolution to the troubles in Europe remained illusive, and a crisis of investor confidence left equity investors poorer in the process. The economic outlook for the fourth quarter and 2012 is even less certain than before.

 

While there was nowhere to hide in the quarter, among large cap stocks, growth outperformed value, although a -13% outcome versus -16% outcome is hardly satisfying. Large cap growth companies outperformed largely due to business mix. Several big technology stocks, which are weighted heavily in the Russell 1000 Growth Index, outperformed, while large US banks, sizable components of the Russell 1000 Value, posted significant declines. Reflecting skittish investor sentiment, large caps outperformed the more economically sensitive and aggressive small and mid cap stocks. For example, the Russell 2000 Index of small cap stocks declined nearly 22%, significantly underperforming the 14% decline in the S&P 500. While the annualized returns for small caps continue to lead large caps over the past ten years, returns for both have been disappointing at best over the past three- and five-year periods.

 

Sector Attribution Review

 

As the sector attribution illustrates, with the exception of utilities, all sectors were weak. Utilities eked out a small gain, benefiting from the substantial decline in Treasury rates during the quarter. In fact, high-dividend-oriented equity styles tended to perform well regardless of sector, as investors expressed demand for current income in the face of the deteriorating equity environment. Beyond utilities, traditional defensive

sectors such as consumer staples, healthcare and telecom outperformed the market. Perhaps surprisingly, technology also outperformed, as some larger weighted index members performed relatively well.

 

In terms of underperformers, investor avoidance of economically sensitive stocks was very clear. Bracing for a global slowdown, materials, financials, industrials and energy were each down more than 20%, underperforming the market. Commodity-based stocks and emerging market stocks in general were hit especially hard in the second half of September. A sharp decline in copper, which is commonly seen as a good coincident economic indicator, was a catalyst for significant sell-off in commodity-related stocks. The price of oil dropped in the quarter as well. While lower oil prices are a plus for consumers in the long run, the decline caused energy investors to take it on the chin for the quarter.

 

Sector performance within the MSCI Global indices returned rankings similar to those of the US. Even the magnitude of the decline in the weaker sectors was similar, highlighting the global nature of the equity downturn in recent months.

 

Earnings Growth has Remained Strong, But Has Likely Peaked for the Cycle

 

S&P 500 earnings reports continued to be strong through the end of the second quarter, but of course, these reports covered business conditions from earlier in the year. Earnings per share (EPS) were up nearly 20% year-over-year compared to the second quarter of 2010. We have expected S&P earnings growth to slow as the recovery cycle advances. Eventually, earnings growth will likely slow to 10% or lower, even if recession is avoided. We simply do not know how quickly this will happen. It depends largely on how business conditions develop over the coming months. Such forecasting is now unusually difficult given the myriad macro crosscurrents.

 

Entering third-quarter earnings season, we anticipate reported numbers will be roughly in line with expectations; however, company managements are apt to be somewhat more cautious on the forward outlook given reduced economic growth forecasts around the world. Earnings revision trends are weakening as analysts have tried to get in front of what is likely to be an edging down of EPS growth. For example, commodity-based companies are currently grappling with lower prices for their products. Financial services companies have noted slower capital markets activity, and we suspect that trading results for the third quarter at the major banks will be soft. On the other hand, some of the major technology companies are expected to report solid earnings and reasonable outlooks. It is our view that the earnings glass is half full, not half empty. Nevertheless, there will be more bumps in the road, and perhaps some potholes for earnings outlooks later this quarter.

 

Sell-side analyst operating-earnings forecasts compiled by Standard & Poor’s place earnings in the $111 range for the S&P 500 in 2012. We think that number will move somewhat lower. If the US avoids recession, which is in line with our economic forecast, we believe earnings of $100-$110 may be achievable next year. If a recession develops, however, it would be reasonable to expect a decline in earnings of perhaps 15% - 25% from recent peaks. Analysts are forecasting earnings of about $98 for 2011 (with two quarters reported and two to go). As such, a 15% - 25% reduction of earnings in 2012 may suggest a range of $75-$85. While this is not our central case, even earnings of $80 would represent a P/E ratio of about 14x based on the current S&P level of 1,150. This is not an excessive valuation by any means. But, if a recession unfolds, we have to expect stocks to move lower before they can move higher on a sustainable basis.

 

The Near-Term Outlook for Stocks is Mixed

 

The US economic recovery hit a soft patch in the late spring, and incoming data continue to disappoint. GDP forecasts have proven to be too high, and employment growth is not taking hold. Corporate operating margins have risen smartly this cycle, but as growth slows, it will be hard to maintain the pace of improvement, and margins may move lower. We believe earnings growth will decelerate, although at this point we continue to expect earnings in 2012 to exceed 2011 results.

 

Stock market valuation indicators point to equities being attractively valued relative to history, and equity valuations appear especially attractive relative to interest rates. However, the equity risk premium has continued to edge higher. That is, even as interest rates have moved lower, investors have been discounting a less certain environment. Concurrent with lower global growth forecasts, P/E multiples have continued to compress. Fundamental issues in the eurozone have no clear solution. Heated rhetoric and testy battles are almost certain to continue in Washington, DC, and we are more than a year away from the next elections. As such, the likelihood of broadly positive legislative action is remote.

 

Where do stocks trade under this scenario? The S&P 500 has traded within a range of about 1,100 on the low end to 1,230 on the high end since the sharp decline of July and August. Complicating the outlook, however, is the fact that many stocks and indices have made new lows since their early August lows, suggesting the S&P 500 could do the same. Fundamental conditions make the 2012 earnings outlook far cloudier than it was one or two quarters ago. While investors may anticipate a traditional fourth-quarter rally, such an outcome is unfortunately not written in stone. Equity performance for 2012 will hinge on future economic developments and company-by-company execution more than ever. This suggests a wide trading range for 2012 both above and perhaps below current levels. While our long-term conviction in equities remains intact, especially at these low historical valuation levels, the near to intermediate term should offer a wide range of outcomes and continued volatility.

 

Russell 1000 Index: measures the performance of the large cap segment of the US equity universe and includes approximately 1,000 of the largest securities based on a combination of their market cap and current index membership. Russell 2000 Index: measures the performance of the small-cap segment of the US equity universe and includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership. Russell 1000 & 2000 Value Indexes are unmanaged market cap-weighted indexes of those stocks of the 1,000 & 2,000, respectively, largest US domiciled companies that exhibit value-oriented characteristics. Russell 1000 & 2000 Growth Indexes: unmanaged market cap-weighted indexes of those stocks of the 1,000 & 2,000, respectively, largest US domiciled companies that exhibit growth-oriented characteristics. Russell Midcap Index: measures the performance of the mid-cap segment of the US equity universe and is a subset of the Russell 1000 Index that includes approximately 800 of the smallest securities based on a combination of their market cap and current index membership. Russell Midcap Growth & Midcap Value Indexes: measures the performance of the mid-cap growth and value segments of the US equity universe, respectively. Standard & Poor’s 500 Index (S&P 500): an unmanaged market cap-weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent US equity performance. MSCI World Index: unmanaged index measuring global developed market equity performance. MSCI Emerging Markets Index: free float-adjusted market cap index measuring equity market performance of emerging markets. MSCI All Country World: market cap weighted index of stocks from developed and emerging markets providing a broad measure of global equity-market performance. All indexes are unmanaged, do not incur fees, and you cannot invest directly in an index.

 

Past performance is no guarantee of future results.

 

This commentary is provided for informational purposes only and should not be construed as investment advice. Any opinions or forecasts contained herein reflect the subjective judgments and assumptions of the authors only and do not necessarily reflect the views of Loomis, Sayles & Company, L.P., or any portfolio manager. Investment recommendations may be inconsistent with these opinions. There can be no assurance that developments will transpire as forecasted and actual results will be different. Data and analysis does not represent the actual or expected future performance of any investment product. We believe the information, including that obtained from outside sources, to be correct, but we cannot guarantee its accuracy. The information is subject to change at any time without notice.

 

Indexes are unmanaged and do not incur fees. It is not possible to invest directly in an index.

 

© Loomis Sayles

www.loomissayles.com