Key Points:
• Many investors remain on the sidelines due to concerns that
the market has gone "too far, too fast." While the
returns have indeed been sensational since March, the sharp
rally is consistent with recoveries from past panic sell-offs.
• The last three months tend to be the best quarter of the year
for the stock market -- and even more so when the market
is strong entering the fourth quarter.
• The yield for the stock market is low relative to historical
standards -- or is it? Compared to interest and inflation
rates from the last 50 plus years, the stock market yield could
be considered attractive.
The third quarter of 2009 was a keeper. The Dow Jones Industrial
Index was up 15% and had its biggest calendar quarter gain since
1998 as well as its best third quarter since 1939. The S&P
500 had its best third quarter since 1970. Smaller companies
and international stocks performed still better on an absolute
basis. Even fixed income securities posted some decent gains,
especially high yield bonds which were up over 14%.
Despite these gains, many investors remain skeptical that the
rally can continue. Numerous investors expect more trick than
treat from the stock market in the foreseeable future. The question
is how much gas can possibly be left in the tank given the robust
gains over the last six months? While it's safe to say
that the "easy money has been made" -- after
all the over-all market is up nearly 60% off the March intra-day
lows -- that doesn't mean the market can't
keep moving higher into year-end.
Frankly, it's not certain how "easy" the
gains have really been during the last six months. Many investors
have not fully participated if one looks at investor sentiment
and allocation surveys. Investor sentiment entering the last
week of September remained net bearish, as it has been for most
of the rally.
The gains since March have been driven by multiple factors,
including improvement of the economic situation. A big factor,
however, is that risk appetites are starting to improve. Actually,
it's more about fear dissipating than greed returning,
as the desire for perceived safe harbors (such as U.S. Treasuries
or the U.S. dollar), is waning.
As a result of the unwinding of the safe harbor trade, we have
seen some market movement that has provided fresh ammunition
to market bears, but it is more likely that this market movement
is simply misinterpreted. A case in point is the U.S. dollar.
The dollar put in a price bottom several weeks before the stock
market went into a panic sell-off last fall, then it reached
its 2009 market peak the same day the stock market reached its
intra-day low. To many, the falling dollar this year suggests
upcoming doom, but in reality, it could just be last fall's
panic trade reversing.
This is not to say the entirety of the gains have been driven
by the concept of less fear. The economic data is getting better,
or perhaps better put, "less bad." Many note that
we may be inside a V-shaped recovery (in other words a sharp
rebound in economic activity after a sharp contraction) and
there are plenty of charts of various economic data ranging
from housing data to manufacturing data to prove that there
has clearly been a large bounce since the start of the year.
This is not to say that the economy is as strong as it was a
few years ago -- it's definitely not -- but
it has vastly improved from the lows.
It should also be noted that a sharp uptick in GDP growth later
this year should not be a surprise. The four deepest recessions
since WWII were immediately followed by two quarters of sharp
economic growth. Despite most economists still expecting a mild
recovery at this point, if that were to actually happen, it
would be unprecedented. To re-state, sharp recoveries usually
follow sharp contractions.
Recently, there was an article written by James Grant that
was published in the Wall Street Journal entitled "From
Bear to Bull." It really was an exceptional read, sort
of like reading about how a person of a certain religious or
political viewpoint may change their point of view. To be fair,
James Grant surely does not consider himself a "perma-bear",
though it has sure seemed that way to many observers for a long
time. At any rate, the essence of the article was that it made
the case that history has taught us an important lesson about
the deepest economic contractions: "the deeper the slump,
the zippier the recovery." Within the Grant article, another
choice quote was from Michael Darda the chief economist at MKM
Partners: "The most important determinant of the strength
of an economy recovery is the depth of the downturn that preceded
it. There are no exceptions to this rule, including the 1929-1939
period."
The current recession, which many call "The Great Recession," is
in fact the deepest and longest economic contraction since The
Great Depression (though the current recession is clearly more
similar to recent recessions in terms of actual economic contraction
than the Great Depression which was truly in a league of its
own). The current recession has witnessed nearly a 4% loss in
real GDP and is starting to approach two years of age. Looking
at the last ten recessions, the average recession has lasted
closer to 10 months in duration, and the average loss in real
GDP has been about 2%. The recent recession was twice as painful
as those averages. "The deeper the slump, the zippier
the recovery."
Nonetheless, how normal is this intense stock market recovery
that we have seen since March? Surely a 60% price gain from
low to high -- and that's just for the S&P 500 which
has lagged more speculative fare -- qualifies as unsustainable.
While volatility this sharp is indeed more the exception than
the rule, it is also somewhat normal to see strong recoveries
following deep sell-offs.
As the market sage Barton Biggs wrote in Newsweek a few weeks
ago: "it's not the percentage change from the lows
that matters; it's the amount of the lost altitude recovered.
In judging how high a tennis ball dropped from a height should
bounce, you would expect a ball dropped from 20 feet up to rebound
significantly higher than the same ball dropped from 10 feet." In
the same article, Biggs cited a study by Morgan Stanley of 19
major secular bear markets (as defined by losses of more than
40%) in a variety of international stock markets and gold. The
average loss was 57%, which is approximately the same amount
that the U.S. (and Europe for that matter) was down from its
October 2007 highs to its March 2009 lows. The study found that
each bear market was followed by dramatic rebounds with the
smallest rally being 41% and the shortest rally lasting 8 months.
The average was 71% and 17 months. The current rally is approximately
60% in 6 months. The current rally qualifies as fast to be sure,
but the gain is still below-average compared to past bears.
Next, let's consider the ten worst 12-month rolling returns
for the S&P 500 over the last fifty year (excluding the
last bear market). In short, the stock market was able to post
a sharp recovery over the next twelve months nine times and
average a price return of 25%. To put recent market action into
perspective, the worst twelve-month return of the recent bear
market was nearly -50% (back in early March). The gain of 60%
since then surely qualifies as yet another sharp recovery, though
prices still need to rally nearly another 20% by next March
for a full recovery.
Fourth Quarter Seasonality
October is a month that scares many
investors. Last year witnessed a 17% sell-off in the S&P
500 index. There are other famous market sell-offs that also
took place in October, including
Black Monday back in 1987. The reputation for the month, however,
is much worse than what the actual experience should suggest.
The month tends to finish higher approximately 60% of the time.
And, over the last 20 years, October has produced an average
monthly return approximately twice the average of the other
eleven months.
The fourth quarter as a whole, however, does deserve its reputation
as being the strongest consistent quarter of the year for stock
market performance. Whether or not one is looking at data from
the last 20 years, the last 50 years, or the last 100 years,
the final three months do tend to produce the highest average
returns.
A common rebuttal to this of late is that the gains from this
September (which on average is the weakest month of the year)
will dampen the fourth quarter effect. According to the BeSpoke
Investment Group though, this is not typically the case. In
short, the fourth quarter tends to be even stronger than average
when the first three quarters of the year posted gains.
Stock Market Yields
Another common knock against the market
these days is that the current indicated dividend yield for
the S&P 500 is
just a smidge over 2%, while the 50-year average is about 3.1%.
In absolute terms, when just looking at yields, the market doesn't
look cheap. And this is true even if the current yield is actually
higher than what the market has generated in any year going
back to 1996 (with the exception of 2008).
In relative terms, however, the dividend yield looks more attractive.
Versus the ten-year Treasury, for instance, the current relative
yield (and excluding the readings since last October) is more
attractive now than it has been at any other time going back
to 1967. At the end of February of this year, the stock market
dividend yield versus the ten-year U.S. Treasury yield was the
most attractive it had been since 1958.
Versus three month Treasury bills, the current relative yield
is still more attractive now than it has been at any other time
going back to 1958 (again excluding the readings since last
October). At the end of February of this year, the stock market
dividend yield was the most attractive it had been versus three
month Treasury bills since 1954.
Looking at the real dividend yield, in other words adjusting
the current yield by the latest inflation reading (the Consumer
Price Index, otherwise known as CPI), the current real yield
is near 4%, which is the highest it has been since 1955.
Bottom line, yields may be low in absolute terms, but relative
to the current level of interest and inflation rates, it can
be reasoned that stock yields look appealing -- not to
mention they retain the ability to grow over time. For the long-term
investor with long-term investment objectives, owning stocks
should look a lot more rewarding than holding an inordinate
amount of cash.
Summary
In sum, we are retaining our bullish bias heading into
the final months of the year. Beyond what was mentioned above,
earnings
are improving, price momentum remains positive, the interest
rate environment is constructive, and investor sentiment remains
doggedly skeptical.
As for our portfolio positioning, we are maintaining our basic
themes. We favor higher quality exposures within our equity
holdings, though we favor lower quality exposures within our
fixed income holdings. Those are the broad themes.
With that said, there has been some modest shifting of views
underneath those broad themes. For instance, while our shift
earlier in the year from a slight growth tilt to a modest value
tilt among our equity funds has been rewarded, we are now looking
to neutralize that view as relative valuations have shifted
again. In addition, within fixed income, we recognize that investment
grade corporate bonds have lost a bit of their attraction versus
other fixed income sectors, including higher quality high yield
bonds. We are already overweight higher quality high yield bonds
(in those client accounts where we feel the holding is appropriate),
but we may tactically add to the position in the near future
depending on market conditions.
As always, these views are subject to change depending on the
various market factors we monitor, some which can change fairly
quickly. And those factors, at least at the end of the quarter,
suggest that investors could expect more treats than tricks
in the coming months.
Sincerely,
