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Stocks Continue Good Gains in Second Quarter
The stock market rally that began last March gained additional momentum in the second quarter. Since then, stocks have enjoyed a nice rebound from deeply oversold conditions. Given the recent rally, it is interesting that the 2009 year-to-date numbers for major market averages have posted only mixed results. The Dow Jones Industrial Average return year-to-date was slightly negative and the S&P 500 Index was slightly positive. The technology-laden NASDAQ Index had the best performance, bouncing double-digit percentages from severe losses in earlier periods.
Stocks now have recovered about 25-30% of the losses that the markets suffered since the 2007 peak. Valuations of stocks still appear to be reasonable, according to many analysts. Based on various metrics such as normalized p/e ratios and price-to-book ratios, S&P 500 stocks are currently priced to deliver total returns annually in the range of 6% to 9% over the next decade (whereas back in March, prior to the recent rally, S&P 500 stocks were priced to deliver long-term annual returns estimated at more than 10%). Investor psychology appears to have changed from extreme risk aversion to a view of better economic times ahead.
CPIC client portfolios have been defensively positioned since last year. Portfolio returns have been similar to major stock market averages – but with significantly less risk than stock market indices – which by definition, are composed of 100% stocks. We continue to obtain the desired portfolio objective: minimize risk consistent with reasonable returns.
The Latest Report from the Federal Reserve
On June 30th, we attended a presentation on the state of the U.S. economy by Federal Reserve Bank of San Francisco President Janet Yellen. The outlook is for an end to the current recession during the second half of 2009. This would mark a trough in the economy following more than 20 months of damage – the deepest recession of the post-war era. The U.S. GDP is expected to contract again in the second quarter. After that, however, economic activity is expected to slowly increase. Third quarter GDP may be positive, with economic growth picking up steam after that. Regarding likely future changes to interest rates by the Federal Reserve, notes from the most recent Federal Open Market Committee meeting state that “economic conditions are likely to warrant exceptionally low levels of the Federal Funds rate for an extended period.” – in other words, low interest rates for now.
The possibility of rising inflation is considered a potential danger only in the distant future. Although the size of the government stimulus programs and injections of liquidity may be causes for concern, the current economic environment of excess capacity, high unemployment rates, reduced consumer spending, and continued depressed housing markets should act to constrain inflation for the foreseeable future. This view is confirmed by various inflation indicators, including 5- and 10-year TIPS breakeven rates.
Current Portfolio Strategy
Monetary, fiscal, and financial policies probably have created a floor for credit and equity markets. Nevertheless, we remain cautious in the near term. Equity markets may move only sideways within a trading range over the next few months in this fragile economic environment. If this is the case, over-weighting a portfolio with bond funds to generate monthly dividends is more likely to enhance returns than over-weighting equities. A portfolio positioned in this way will obtain the additional benefit of less downside volatility with a heavier allocation to bonds than to stocks. This is exactly how we have positioned CPIC portfolios.
Investment objectives for CPIC portfolios are a balance. We want to minimize losses that may occur in equity mutual funds if more negative financial surprises cause unanticipated stock market declines. At the same time, we strive to achieve portfolio returns that are higher than cash and money market fund returns. Thus far in 2009, we have successfully achieved both objectives! |
