New Market Commentary

October 6, 2009

Trick Or Treat

The stock market has settled back about 4% during the past two weeks. This correction is not surprising in view of a 58% rise since the March low and a 15% return in the third quarter. Simply put, the market got ahead of the fundamentals. Despite blips here and there, the underlying fundamentals for the economy and profits are improving, but not as quickly as the stock market has believed. While more volatility may lie ahead over the near term, we believe that the cyclical bull market will remain in tact and the S&P 500 may reach 1200 in 2010.

A series of economic indicators during the late summer pointed the way towards recovery. More recently, the course of barometers of growth has turned mixed. Nevertheless, underlying trends are improving. For example, the September jobs report was disappointing. The decline in non-farm employment was greater than expected. Nonetheless, the absolute number of jobs lost, 263,000, was considerably less than the 700,000 lost earlier this year. Because of seasonal forces, it is likely that the jobs number for September will be revised lower in the October employment report. Still, third quarter growth for the economy is likely to be about 3.5% thanks to inventory rebuilding. However, the fourth quarter will require final sales to pick up and for this to happen; the consumer will have to loosen their purse strings. At the moment, retailers say they will be happy with flat sales in the final quarter of the year.

Looking ahead to 2010, global growth is expected to be 3% and the U.S. should do 2-3%, well under the typical 6-7% recovery from a recession. Consumers remain concerned about their incomes, jobs, and wealth. Moreover, credit availability remains tight for them compared to credit conditions during the last ten or more years. Deleveraging continues and savings rates continue to rise. It would appear that efforts, helped by a lower dollar, and business spending, aided by a strong corporate cash position, will need to fill some of the demand gap produced by a constrained consumer.

Third quarter profits results start to flow this week. In each of the previous quarters, investors were pleasantly surprised that most quarterly earnings were better than expected thanks to cost cutting. With stocks up more than 50% from their March lows, it will be harder to produce positive earnings surprises than it was in the first half of the year when stock prices were much lower. Investors will be looking to management guidance for the remainder of 2009, and especially 2010. They will be particularly interested in the outlook for orders and eventual sales growth.

The markets momentum has been impressive. A nearly 60% rebound from the markets low is reminiscent of the major rebounds by the market in the early and again in the late 1930s. Advances have substantially outpaced declines. Small and mid cap stocks have outpaced large caps. Emerging markets and junk bonds have been the strongest performers. More recently, speculation picked up in low priced stocks. One chap mentioned to me that he bought a stock for $0.40 and sold it shortly thereafter for over $3.00! Meanwhile, insider selling has been rising and the number of secondary stock sales recently surpassed their previous highs in the late 1990s. Sounds to me that some of the “smart money” has moved to the sidelines. Moreover, hedge funds were shorting more aggressively as the third quarter closed.

Presently, the best values among all risk assets are large cap quality stocks. As mentioned already, the higher risk small and mid cap equities have performed strongly in the markets rebound since March. In contrast, the large cap quality stocks have lagged. Given the likelihood of a moderate recovery in the economy, we believe the large caps will produce relatively positive profits growth, in part, aided by the lower dollar.

A. Marshall Acuff, Jr., CFA
Managing Director
Chair, Cary Street Partners Investment Committee
Cary Street Partners Investment Advisory, LLC