Market Commentary by Mark Schmeer

 

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The Economy

As key indicators continued to move into positive territory, the U.S. economy gained strength in the first quarter of 2010. Fourth quarter 2009 gross domestic product (GDP) growth was a robust 5.6%. However, more than a third of that figure can be attributed to a slowdown in inventory reductions, leaving a much more modest level of growth from other factors. Consensus expectations for first quarter 2010 GDP below 5%.

Consumer confidence has been stubbornly low even though both spending and personal income have moved higher. Consumer spending gains were restrained by ongoing concerns about jobs and housing. An increase in personal income over the past six months has been almost entirely the result of stimulus spending, which is temporary. However, a positive March employment figure may help begin to rebuild confidence in a sustainable recovery. Approximately 162,000 jobs were added to the labor markets in March. A good percentage of those jobs were the result of the government hiring of census workers, who are temporary. Nevertheless, a shift from job losses to job gains is a positive sign for consumers - and the economy at large.

The housing market is showing signs of stabilizing, but it still remains weak as foreclosures keep pressure on prices. New and existing home sales increased in the second half of 2009, as new home buyers responded to the federal tax credit offer. However, the credit was set to expire in November, and sales fell off dramatically as the expiration date neared then failed to revive much when the credit offer was extended to April 30, 2010. On the pricing front, seasonally-adjusted data showed eight consecutive months of modest improvement; without the seasonal adjustment, prices were relatively flat. Either way, prices appear to have stopped falling, and that is good news.

Manufacturing activity showed solid improvement in the first quarter. Exports have been an area of strength. However, the U.S. economy is not getting the full benefit of a weak dollar because the Chinese renminbi, which is linked to the dollar, also fell. In this environment, the Fed remained on the sidelines, and the target federal funds rate was held between zero and 0.25%.

EQUITY REVIEW

Rising corporate earnings helped fuel stock market gains in the first quarter. The S&P 500 Index rose 5.4%. Small- and mid-cap stocks outperformed large-cap stocks by a comfortable margin and value outperformed growth, as measured by their respective Russell indixes. The technology-heavy Nasdaq Composite^® rose 5.9%, even though technology logged only modest gains. Industrial, consumer discretionary and financial stocks were leaders, buoyed by improving economic conditions. Telecommunications and utilities stocks lost ground while all other economic sectors in the S&P 500 Index gained. Energy stocks were nearly flat, with a 0.08% increase for the quarter.

U.S. stocks beat out foreign stocks in both developed and emerging markets. The MSCI EAFE Index was up, with a return of 0.9% in U.S. dollars. Solid returns from the stock markets of Nordic countries and from Japan were offset by weak performances in major eurozone countries, as debt concerns in Greece and, to a lesser extent, Portugal, Spain and Italy, made headlines. After a year of outsized performance in 2009, emerging-market gains were subdued in the first quarter. The MSCI Emerging Markets Index rose 2.1%, hampered by losses in China and Brazil.

FIXED-INCOME REVIEW

The modest returns of the investment-grade bond market mask a shift in the 10-year U.S. Treasury yield, which fell then rose up to end the quarter at 3.8% - just about where it started. Treasury auctions fared poorly as the supply of government bonds increased. Treasury prices were just about flat and returns generally equaled yields. Against this backdrop, the Barclays Capital U.S. Aggregate Bond Index gained 1.78% for the quarter. The Barclays Capital High Yield Index was up 4.6%, as the yield gap between Treasuries and high-yield bonds continued to narrow.

OUTLOOK

We believe that growth could surprise on the upside in the first half of 2010. Consumer spending is likely to move higher while inventories move lower, which should strengthen the underpinnings of this recovery. Yet growth in the second half could be muted and, the expiration of the Federal Reserve's mortgage-backed securities purchase program could send mortgage rates higher which would create a less favorable environment for the stock market. Yet stronger-than-expected fourth-quarter 2009 earnings reports have resulted in a higher earnings forecast for 2010. Our current forecast is $82 per share for S&P 500 Index companies - above the high-end of the range that we established earlier in the year and higher than current consensus expectations of $79 to $80 per share. With those factors in mind, here are the strategies that we favor in the period ahead:

1) Buy on the dips and sell on the rallies. Although the recent stock market rally may not be ready to expire, sentiment has started to percolate higher and it may be difficult for stocks to move significantly higher in the short term because most investors are already bullish.

2) Consider dividend-payers and dividend-growers. corporate Stocks that pay dividends offer some downside protection. Seek out companies that have a history of raising their dividends and sectors that are cash rich, such as energy.

3) Go global. Valuations are more attractive, especially in Japan and Europe. And a weak dollar makes return prospects from foreign markets even better. The Canadian dollar is one of our favored currencies. Be careful in emerging markets. Their economies are growing faster, but valuations are higher and there are signs of a bubble in China, where returns have been extremely high.

4) Target high-yield and investment-grade bonds. Even if we do see some modest increases in interest rates over the course of the year, we think yield spreads will narrow and both high-yield and investment-grade bonds will continue to generate attractive returns. High-yield bonds historically have performed in line with the stock market while investment-grade corporates have more modest potential.

The performance data contained within this material represents past performance, which does not guarantee future results. Performance, especially for short time periods, should not be the sole factor in making your investment decision.

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