The second quarter included a series of crises and developments that challenged the widely held view that the economy was experiencing a strong, sustainable recovery.  In the face of growing storm clouds, equities and other risk assets sold off sharply in the quarter giving back all of their year-to-date gains and then some.  As measured by the S&P 500 Index, the stock market suffered a 15.0% correction from its April 23, 2010 high through June 30.  This brought total returns for the year-to-date to -6.7%.

What happened?  Basically nearly all key economic indicators softened during the quarter raising concerns that the recovery in economic activity and corporate profits observed over the past several quarters would prove fleeting.  Housing and auto sales, manufacturing order levels, employment trends and consumer confidence all showed signs of easing during the second quarter.

Housing sales, which had been bolstered by the Federal tax credit program, sagged as that program wound down, with sales of both new and existing homes falling in May.  Auto sales experienced weakness in June.  Most importantly, as temporary census workers were laid off in June, overall employment levels dropped.  Private employment gains could not make up for the decline in government workers.  Unemployment did drop from 9.7% in May to 9.5% in June, but most economists pointed to a decline in the labor force as the key reason (i.e. people were leaving the labor force rather than being hired).  Finally, as a result of accumulation of unfavorable economic news, consumer confidence lurched sharply downward in June, falling to 52.9% in June from 62.7% in May.

Contributing to this sense of unease was, of course, the euro crisis stemming from years of poor economic management and excess public debt in Greece and the other “PIIGS” (Portugal, Italy, Ireland, Greece and Spain). Massive and coordinated intervention by the European Central Bank (ECB) and the International Monetary Fund (IMF) was required in early May to keep the European financial system from seizing up.  Until the approximately $1.0 trillion rescue plan was put in place, interbank lending had ceased, credit issuance had all but dried up and foreign exchange markets were pummeling the euro.  Most observers we admire believe the euro crisis will be contained in the near term and that Greece and the other PIIGS will gradually reduce their fiscal deficits, but ultimately ratios of debt to GDP may rise to unsustainable levels and force Greece and possibly other PIIGS to abandon the euro. 

In our last Investment Outlook, we cautioned that the build up of government debt could eventually spark the next financial crisis.  Greece is a small example and a forewarning.  The other “Club Med” countries are working hard to contain their problems and will most likely succeed but at the cost of significantly slower economic growth near term.  Meanwhile, back at ranch-USA, things are not all that encouraging either.  Continued economic recovery looks increasingly dependent on the ability of the Federal government to continue deficit spending at an unprecedented rate.  A disturbing number of states and local governments are facing very ugly budget problems as well.  As a result, we expect significant cuts in state and local government employment.

Voters are clearly growing increasingly concerned about these fiscal pressures and we expect the Democrats to lose significant support in the mid-term elections.  Take health care reform:  The legislation passed by Congress did nothing to rein-in the ever increasing rise in health care costs.  Rather, what the politicians referred to as health care reform really meant insurance reform aimed at covering some 30 million of the uninsured.  It doesn’t take a genius to figure out that this will add to the Federal deficit in the coming years.

The problems with so-called health care reform are unfortunately symptomatic of other policies favored by the current administration.  A clear preference to turn to new and expanded government programs to address the current economic weakness and long-term societal needs, has alarming implications for both future tax burdens and the long-term health of the private sector.  Business confidence is low and reluctance to add to payrolls is understandably high in light of great uncertainty over future tax rates, the increased regulatory burden and the cost of staffing.  A sense that the administration and a Democrat-controlled Congress never miss an opportunity to scapegoat and blame the business community does not help.

With all these negatives showing up, it is no wonder the stock market sold off in the second quarter.  We have long argued that the current economic recovery would prove anemic by historic standards.  Unemployment would likely remain stubbornly high, consumer spending restrained and housing unable to play its traditional role of the engine pulling the economy out of recession.  We were, therefore, bewildered by the strength of the stock market in the first quarter.  Now things seem more in balance.

Offsetting the list of negatives we just enumerated are a number of favorable trends.  First, monetary conditions and other policy supports appear quite favorable to economic expansion and to higher equity prices.  Second, corporate balance sheets are very strong and should enable companies to spend on capital improvements – especially those that support productivity gains.  Third, inflation appears to be under control.  Some argue that deflation is really the bigger near-term risk.  We agree and take the position that inflation may be a longer-term issue but not likely in the next 12-18 months.  Finally, thanks to the recent stock market correction and a robust bounce back in corporate profits from recession lows a year ago, equity valuations seem quite reasonable.  We believe that some individual stocks are true bargains again. 

The other major positive is that the U.S. remains a haven.  In a world in which money can flow easily from country to country, one must always compare what is happening in the U.S. to what is happening elsewhere.  Problems in Europe or a possible slowdown in China’s growth rate make the U.S. look relatively more interesting to investors, despite the many negatives that may adversely affect our economic growth rate. 

We do not believe that our economy is headed towards a serious double-dip recession, but rather towards a slowdown or moderation of its growth rate.  That is, the economy has been improving, just not as fast as investors envisioned earlier this year.  We therefore are staying the course, focused on solid companies with strong or improving balance sheets and a history of stable or growing dividends.  We are also keeping some cash as a buffer against further erosion in the overall market and as a buying reserve to use when compelling bargains emerge.  Given all the different factors offsetting the stock market, it is difficult, if not foolish, to make hard and fast predictions about either the economy or the market.  It is, however, much easier to identify companies with improving fundamentals and attractive valuations.    

                                                                     

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Past performance is no guarantee of future results.  This commentary contains the current opinions of the author as of the date above, which are subject to change at any time.  This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product.  Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed. 

 

The S&P 500 is a market-capitalization weighted index of five hundred unmanaged common stocks and is widely recognized as representative of the equity market in general.  The index does not incur expenses and is not available for investment.  Index returns reflect the reinvestment of dividends and interest.

(c) Osterweis Capital Management