News

Market Review and Investment Environment

Posted by: JAKE HARPER

Posted on: August 5, 2011

Financial markets are selling off this week amid growing investor concerns about the health of the U.S. economy. The market’s behavior has become more volatile of late as expectations are being recalibrated. Investors are clearly beginning to price in a greater probability for a double-dip recession, as we see another round of “risk off” trading. Higher risk asset classes such as REIT’s, cyclicals, and high yield bonds are suffering the most while safe havens such as U.S. Treasury bonds are appreciating amidst another “flight to quality”. Contrary to what many may think, this sell-off is not directly related to the U.S. debt deal recently passed by Congress, although we believe a general lack of confidence in government plays its part.

Below is a review of recent developments and our current thoughts on the matter:

On the economic front:

U.S. GDP for the second quarter came in at 1.3%, much less than we had forecast. Just as important, first quarter GDP was revised down to a surprising 0.4% (from 1.9%) indicating the economy is teetering again on recession.

While the prospects of a double dip recession have probably increased to perhaps 15%-25%, we believe they are still well below 50%.

On the markets:

High risk asset classes are selling off steeply. Over the last five days, REIT (-6.56%), Industrials (-6.09%) and small caps (-4.68%) have all lagged the S&P 500 (-4.66%). We would expect this in a “risk off” trading environment.

Investments are flowing from high risk asset classes into U.S. Treasury bonds, as we have seen in the past. Over the last five days, high yield bonds have sold off (-3.04%) while U.S. Treasury bonds have gained (+2.69%). This is flight to quality in action.

Current yields on 10-year U.S. Treasury bonds are down significantly, trading at 2.55%.

Outlook: We continue to favor large cap U.S. equities over high risk asset classes (and have for some time). We continue to favor growth over value, although dividend payers are also a plus since they provide some downside protection in steep sell-offs.

On fundamentals:

Over the long-term, markets trade on fundamentals and less on market sentiment. We continue to view current market valuations and earnings estimates as a strong positive case to remain invested in equities, particularly large cap stocks.

For 2011, Standard & Poor’s forecasts earnings of $98.98 per share for a forward P/E ratio of 12.6X. Note approximately 74% of Q2 earnings have been reported, and were generally in-line or better than expectations.

For 2012 Standard & Poor’s forecasts earnings of $113.79 per share for a forward P/E ratio of 11.0X. We see valuations are fair to cheap given the economic environment.

Corporate management continues to report that business conditions are neither negative or positive but ok. This essential represents a status quo perspective.

The current dividend yield on the S&P 500 index is approximately 2.06%, not to distant from the current 2.55% yield on US Treasury bonds.

Outlook: We acknowledge the potential for lower future earnings estimates in the event of slower U.S. economic growth. However given our meager but positive U.S. growth forecast coupled with the reality that 50% or greater of S&P 500 revenues are generated abroad, we do not believe downward earnings revisions are probable. Finally, we do not believe dividends are likely to be reduced in any case. The yield alone on large cap stocks makes them attractive relative to other asset classes. Stocks likely to hold up better in this type of market will have higher financial quality, more diverse products and or services with meaningful overseas sales.

CMC provides capital market, investment manager and economic research to financial professionals (for more information about Capital Market Consultants, Inc. see our website at www.cmarkc.com).