New Market Commentary

November 2, 2009

A Break in the Cyclical Bull Market

September and October have passed without the high levels of volatility historically associated with these key months on the investment calendar. Nonetheless, the S&P 500 declined 2% for the month of October. This weakness represented the first monthly decline for that index since the March lows. With the advent of November, the stock market enters its seasonally favorable period until April. Given over a 60% advance by the S&P 500 from its Spring lows to its recent high, investors are asking how much more upside is left.

Since March, the stock market has retraced 50% of its decline from its October 2007 high of 1500 for the S&P 500. On a technical basis, it is normal for a market or a stock to retrace 50% of its loss. Moreover, it is normal for the market to pause or react when it reaches a down trend line from the prior major high. This trend line crosses just north of 1100, which is where the recent weakness in the market began. Fundamentally, the stock and credit markets have normalized since this time last year. Normalization means that credit spreads have returned to more normal relationships and stocks have returned to fair value. In the process of normalization, investors returned to taking more risk than they were willing to at this time last year and early 2009. In fact, the best performing areas have been ones associated with the highest volatility: emerging markets, small cap stocks, and high yield debt. Finally, as we have observed previously, stocks had begun to move ahead of their fundamentals. Most, if not all, valuation advancement has occurred. Fundamental improvement in profits is now needed to drive the market higher.

Meanwhile, the cyclical bull market since March has entered a correction period. In our opinion, the downside risk for the S&P 500 is 980-1000. Interestingly the stock market began to correct as the strongest quarter in several years was being reported for the economy. The market’s negative reaction to the 3.5% growth in the third quarter is not surprising because much of that growth is not likely to be recurring in the quarter ahead due to the absence of the “clunkers” stimulus and other stimuli which are expected to have a lessening effect. Thus, top line growth for the economy now appears to be headed toward 2-3% with global growth at the high end of this range. Unfortunately, this projected level of growth will do little to alleviate the challenge of unemployment. While the recession is over, the recovery will be slow with bumps along the way. For many people the economy will feel as if it is still in recession. Moreover, governments do not have the financial flexibility to provide meaningful additional stimulus. In reality, governments of all levels will be in a cut back mode. While all of us are worried about future inflation, deflation/disinflation remains more likely for some time. Pricing power will be limited and managements will reach limits for further cost cutting. Consequently, the visibility of meaningful profits improvement is not clear. The stock markets reaction in recent days is telling us that others share this view.

Looking at the stock market over the next 12 months, we believe a trading environment will come into play until the fundamentals for profits actually turn more positive as a result of increased top line growth. Most asset classes do not represent good value at this time. In the publicly traded markets, large cap growth stocks offer the best value because they have lagged other types of equities. Yet in a slow recovery for the economy, their fundamentals should hold up. Moreover, their multinational orientation will be a plus as economies overseas recover. On weakness, they appear to be the best situated publicly traded asset class. Event driven, merger arbitrage, and distressed strategies also should be successful.

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