May 2010 Market Recap

They sold in May and went away

The old saying about the stock market, “sell in May and go away,” certainly rang true last month. Markets sold off considerably, after posting strong gains since the February sell-off. Volatility spiked sharply higher, as markets digested the Greek debt situation and its effect on the global recovery. Investors again became risk-sensitive and sought safety in U.S. Treasuries. Regulatory reform, which could significantly dampen future bank profits, weighed heavily on financials and the broad market.

Domestic equity markets declined sharply, with the S&P 500 Index down 7.99 percent and the Dow Jones Industrial Average (DJIA) off 7.56 percent. May was the worst month since February 2009, when equity markets declined almost 12 percent, and a wake-up call for investors to keep a sharp focus on the market’s inherent risks—particularly at this early stage of economic recovery.

Overseas markets also had a challenging month. The Europe-heavy MSCI EAFE Index lost 11.51 percent, while the riskier MSCI Emerging Markets Index, down 9.18 percent, lost less, demonstrating that the contagion was centered in Europe.

The bond market benefited from the turmoil, with investors seeking the safety of U.S. Treasuries. Yields on the 10-year Treasury dropped more than 0.50 percent, from 3.83 percent at the beginning of May to 3.30 percent by month-end. This helped prop up the Barclays Capital Aggregate Bond Index, which rose 0.84 percent.

The Treasury rally helped to substantially offset declines in credit-sensitive corporate bonds and high-yield securities, as spreads widened sharply. Fixed income, however, could face pressures in the near-term; the volatility in equity markets could result in further deterioration in credit-sensitive corporate bonds. With Treasury prices trading at recent highs, we could see some price pressure at these levels. The BarCap Aggregate Bond Index, however, has gained 3.71 percent for the year, so investors have been well compensated for holding core bond positions.

Why so much concern over Greece?

The catalyst for the market sell-off was the Greek debt situation, which hit a crisis point in early May. The European Central Bank (ECB) had guaranteed €110 billion to Greece, enabling the country to roll over its maturing debt. But the bank saw that the contagion would likely spread, prompting it to offer a new loan package—€775 billion (roughly $1 trillion)—to support other European nations. These measures were first met with enthusiasm, as global markets rallied, but the austerity measures demanded of Greece proved aggressive. Public unrest in Greece sent a chilling message to markets around the world, which traded sharply lower.

Greece’s chronic problems highlight those of other countries with excessive debt-to-gross domestic product (GDP) ratios and ever-mounting total debt. As a condition of receiving loans, Greece is required to reduce its debt-to-GDP level from 13.60 percent to 8.10 percent, which means a substantial cut in the government’s budget, particularly for salaries and services. Many investors are also concerned about excessive budget deficits and indebtedness in Europe and the U.S.

In addition, European banks hold substantial amounts of eurozone sovereign debt. Typically a low-risk investment, the crisis has led to credit downgrades and a negative impact on sovereign debt, which down the road could raise questions about the solvency of many of the larger European banks.

Is the economic recovery sustainable?

The critical question for investors is, can the recovery continue, or will it stall, leading to a double-dip? The consumer has shown strength, with retail sales pushing 0.40-percent higher in April, after a revised 2.10-percent increase in March. Consumer confidence is at a two-year high, at 63.3 in May, up from April’s 57.7 level. The market sell-off could impact consumer confidence, but, for the time being, the consumer is helping to support the improving economy.

Housing might be a challenge, given the expiration of the first-time homebuyer’s tax credit. New home sales surged 14.80 percent in April from March, after rising substantially the previous two months. Buyers were looking to sign contracts before the tax credit expired; housing activity could decline now that the credit is gone. But continued strength in manufacturing supports the case for an improving economy. The ISM Manufacturing Index ticked up to 60.4 in April, a six-year high, and strength in durable goods orders indicated that manufacturing will remain strong.

In short, the economic outlook is improving, but there are concerns that growth will slow. It is critical that we add jobs to help fuel future growth and spending; an unemployment rate of 9.90 percent may threaten recovery.

What next?

Volatility in the equity markets is indeed back. In May, the average daily range for the S&P 500 was 30 points, or 2.50 percent, versus an average of 13 points, or 1.10 percent, for the first four months of the year. For the DJIA, the average range was 318 points, or 2.80 percent, compared with 174 points, or 1.60 percent, at the beginning of 2010. These are big swings and suggest that investors must be wary of risk and ensure that portfolios are positioned to weather potential storms. Given that equity valuations have moved lower on the market decline, there are better buying opportunities, but, again, be cautious.

Disclosure: Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. All indices are unmanaged and investors cannot invest directly into an index. The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. The Dow Jones Industrial Average is a price-weighted average of 30 actively traded blue-chip stocks. The MSCI EAFE Index is a float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI Emerging Markets Index is a market capitalization-weighted index composed of companies representative of the market structure of 26 emerging market countries in Europe, Latin America, and the Pacific Basin. The Barclays Capital Aggregate Bond Index is an unmanaged market value-weighted index representing securities that are SEC-registered, taxable, and dollar-denominated. It covers the U.S. investment-grade fixed-rate bond market, with index components for a combination of the Barclays Capital government and corporate securities, mortgage-backed pass-through securities, and asset-backed securities. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a nondiversified portfolio. Diversification does not ensure against market risk.

Authored by Simon Heslop, CFA®, director of asset management, at Commonwealth Financial Network.

© 2010 Commonwealth Financial Network®

Commonwealth Financial Network

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