Market Commentary – September 2010

Equities ease lower, bonds up again

In August, markets gave back more than half of their July gains, and most equity markets saw negative returns for the month. The S&P 500 Index lost 4.51 percent for August, and the Dow Jones Industrial Average lost 3.91 percent; the indices are negative for the year by 4.62 percent and 2.11 percent, respectively. It has been the worst August since 2001 and the only losing August in the past five years. The markets threw investors a curveball, and we did not see the summertime market rally that many analysts had predicted. Now markets need to regain momentum in what has been a slowing economic recovery over the past several months.

Interest rates continued to plummet across all maturities in the U.S., as investors showed a healthy appetite for U.S. Treasury debt. Yields on the 10-year Treasury fell from 2.91 percent at the end of July to 2.48 percent at the end of August—the largest monthly decline in yield since the credit crisis began in November 2008. Yields on the 2-year dropped further, ending the month at 0.47 percent, within a couple basis points of the August 24 all-time low in 2-year yields of 0.45 percent. The fall in rates helped bolster bond returns yet again, and the Barclays Capital Aggregate Bond Index rose 1.29 percent, leaving it 7.83 percent higher for the year.

Municipal bonds had a very strong month, with the Barclays Capital 10-Year Municipal Bond Index returning 2.77 percent and now up 8.76 percent for the year. Longer-maturity municipal bonds have been helped both by the move lower in interest rates and improvements in bond prices relative to Treasuries. Although many municipalities are feeling the strain of the economy, it seems that investors are looking past these issues and are less fearful of longer-maturity paper in general.



The Federal Reserve has helped drive bond markets

Bond yields have been falling since April of this year, as investors continue to pour money into bonds and bond funds. This has confounded many analysts and economists who had been looking for yields to rise throughout 2010 on fears of inflation.

The Fed has been a strong catalyst for the move to bonds, as it pushes forward with its program of quantitative easing—short-hand for printing money. But instead of printing money, the Fed is using electronic adjustments to its accounts to buy securities on the open market. This activity has indeed led to the desired result, keeping interest rates low for the foreseeable future.

The Fed purchases have also prompted speculators and investors to buy across the yield curve, helping to spur the rally in longer-maturity bonds. When the Fed begins to change course, there is the risk that bond prices may fall and that yields, consequently, may rise. But, at least for the near-term, investors have seen strong outsized gains at the longer end of the yield curve.

The recovery continues to slow

The recovery has indeed slowed, which is evident in much of the economic data released as of late. The biggest indication was the gross domestic product (GDP) estimate for the second quarter, which showed the economy growing at an annualized rate of 1.60 percent, a level below the long-term trend. GDP also declined for the previous two quarters, since its 5-percent high reached in the fourth quarter of 2009, a result of the massive stimulus injected into the economy (Please see chart).

Quarterly Changes in GDP: March 2008–June 2010

Given the slower economic growth, it will be more challenging for companies to grow revenue in the near-term. The slowing recovery has certainly been a concern for the Fed and has, in part, been a catalyst for the quantitative easing program, designed to help reignite the economy.

The sluggishness of the recovery is more than evident in the lack of job growth seen across the economy. The unemployment rate has been sticking at the 9.50-percent mark, and current forecasts suggest that hiring won’t improve any time soon. The housing market has also deteriorated, turning downward over the past two months. Existing home sales were 3.83 million in July, and new home sales showed only 276,000 units sold. Both were well below forecasted numbers and considerably below levels that would support a stronger recovery.

Housing and employment have no doubt put a damper on consumers who, for the most part, have been showing unusual frugality. Consumers have shifted to lower-priced stores, deferred big-ticket items, and demonstrated a new propensity toward saving. As of June 2010, the personal savings rate is 6.40 percent, way up from a level that was close to zero during the “go-go” years before the recession. Although it is good for people to get their finances in order, the trend is not helpful for supporting a higher level of economic activity.

Where does this leave us?

Markets continue to exhibit volatility. For the most part, they are at similar levels to a year ago, which has been discouraging to investors looking for returns on invested capital. And with the slowing economy, there is the risk that markets may react badly to potentially deteriorating economic data.

So, again, this is a time to be mindful of risk in portfolios to cushion against volatility moving forward. It is also a time where a focus on income may help to bolster returns, given that capital appreciation strategies, based on an upward-trending market, may prove elusive.

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 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. The Barclays Capital 10-Year Municipal Bond Index is an unmanaged index with maturities between nine and twelve years.

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

© 2010 Commonwealth Financial Network®

Commonwealth Financial Network

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