Q3 2010

The third quarter of 2010 witnessed a strong bounce in equity markets, reversing the double-digit declines from the second quarter and recording the strongest September return for the S&P 500 since 1939.  The S&P 500 index gained 11.3% in the third quarter and is now up 3.9% for the year to date through September 30th.  Every sector had a positive return for the quarter with the Telecom, Materials and Consumer Discretionary sectors leading the advance.  Outside of the US, equity markets performed just as well with an average return of 16%.1

The macroeconomic data for the last four quarters has been mostly positive in the US.  The personal savings rate is now 5.8% (up from 0% in 2004), GDP has grown 3% year over year through the end of June 2010 with business investment expanding 24% from the middle of 2009.2 Consumer spending and income has increased despite an aggregate reduction in household debt and consumer confidence at a 20 year low.  All of these factors have translated into record profits for American corporations.  Annual operating earnings for the S&P 500 index are on track to match the previous high water mark of $82.50 per share in 2007 in an environment of low inflation and record low interest rates.  However, these positive data points have not overcome the psychological damage inflicted by the events of 2008.  Headlines about the unemployment rate, public debt levels and higher future tax burdens have disproportionately influenced the risk-reward decision process, keeping most high quality stocks well below their 10 year average valuations.

The current “all or nothing” mentality of market participation is driving stock return correlation to the higher end of the historical range and leaving fundamental valuation behind in a steady stream of macroeconomic headlines.  Predominate fear of capital loss has allowed corporations and the federal government in the US to issue debt at record low rates of interest.  At the end of September, the US Treasury sold 5-year notes at 1.26% and Microsoft sold 5-year notes at 1.72%.  Both of these debt auctions were oversubscribed by 3 times the amount on offer and both auctions produced the lowest yield ever recorded for a 5-year maturity, respectively.3,4 This comes as no surprise to anyone watching the mutual fund and ETF flow of funds in 2010.  Individual investors have been steadily shifting their portfolio allocations away from equities and into fixed income funds throughout the year.  Fixed income fund managers are replacing bond holdings as they mature in addition to buying new bonds to soak up all the cash placed under their management.  It certainly seems that the investor sentiment pendulum that caused “irrational exuberance” to enter the lexicon in the late 1990’s has swung to the other extreme in 2010 as “irrational despair” subverts any optimistic view of the future.  In our view, well-run corporations with historically high earnings yields, higher than average dividend yields and international revenue streams will outperform other asset classes in the years ahead.

1.       Standard & Poor’s – www.standardandpoors.com

2.       U.S. Department of Commerce, Bureau of Economic Analysis – www.bea.gov

3.       Deborah Levine, Treasury sells 5-year notes at lowest yield ever, MarketWatch, September 28, 2010

4.       Katy Burne, Record Low Yields for Microsoft, Wall Street Journal, September 23, 2010

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