Market Update for the Month Ending July 31, 2012

Market Update for the Month Ending July 31, 2012

Presented by Sean Gross, CFP®, AIF®

Financial markets take one step back, two steps forward

• July was a volatile month, with uncertainty—economic and political, domestic and international—driving that volatility.
  • The S&P 500 Index moved more than 2 percent up and down, before ending July up 1.39 percent.
  • The NADAQ showed similar volatility and wound up essentially flat, with a small positive move of 0.15 percent.
• Domestic stocks suffered from announcements of a slowing economy as evidenced in lower corporate earnings.
  • 71 percent of S&P 500 companies beat estimates, as of the last week of July.
  • Only 43 percent beat top-line revenue estimates, the lowest percentage since the first quarter of 2009.
• U.S. stock market technical indicators improved slightly over the month.
  • The 50-day moving average for both indices was well above the 200-day moving average.
  • The S&P 500 has traded in a well-defined channel since early June (see chart).
  • Equities ended July toward the upper bounds of the channel.

• International stock markets up, but not enough for technical indicators to improve.
  • The MSCI EAFE Index was up 1.13 percent.
  • The MSCI Emerging Markets Index was up 1.61 percent.
  • Despite the improvement, technical indicators remained weak.
• The dominant influences were actions by official institutions.
  • On July 5, the European Central Bank (ECB) and the People’s Bank of China announced rate cuts within minutes of each other.
    • This fueled rumors of coordinated action.
  • Toward month-end, ECB President Mario Draghi said that the bank would do whatever it took to support the euro.
    • Investors extrapolated that the ECB might ramp up purchases of peripheral European debt.
    • This resulted in a bounce back in demand for European equity and debt.
• Slowing growth around the world and political uncertainty benefited fixed income.
  • U.S. Treasury yields declined to all-time lows in July.
    • After going below 1.5 percent, yields on the 10-year fell to 1.38 percent.
    • They rebounded on Mr. Draghi’s pledge to preserve the euro.
  • The Barclays Capital Aggregate Bond Index returned 1.38 percent for the month.
  • U.S. Treasury yields are at historic lows, but they remain higher than yields in Germany, Switzerland, and Japan.
• Investors continued to gravitate toward risky bonds.
  • The Barclays Capital U.S. Corporate High Yield Index gained 1.90 percent in July.
  • Low default rates and reasonably attractive spreads have resulted in the high-yield index outperforming the Barclays Capital Aggregate Bond Index year-to-date.
  • On an absolute basis, yields are very low compared with historical standards, but relative to Treasuries they are near average levels.

While U.S. stock market technical indicators improved slightly, valuations are fair to high by historical standards. International markets are weaker on both an absolute and a technical basis, and seem to depend significantly on governmental action; however, they are more reasonably valued than U.S. equity markets.

Focus on uncertainty from Washington, DC

• In late June, the Supreme Court ruled that “Obamacare,” formally the Patient Protection and Affordable Care Act, was constitutional, laying the grounds for implementation.
  • The ruling removed uncertainty over the act.
  • But it also guaranteed taxes would rise by at least the amounts written in the bill.
  • And it increased the perceived stakes in the upcoming election, with Republicans vowing to repeal the bill if they take control of the government.
• Growing awareness of the consequences of the fiscal cliff also increased uncertainty.
  • The fiscal cliff describes the tax increases and spending cuts that will take effect at year-end unless explicitly repealed.
  • It is estimated that these tax increases will cut anywhere from 3 percent to 6 percent of gross domestic product (GDP) at the start of next year.
    • Given growth under 2 percent, this would likely mean a recession early next year unless Congress acts.
• The U.S. will hit the federal debt ceiling by early fall, well before the election.
  • We may expect that this year’s process will be as disruptive as last year’s.

These factors have acted to increase uncertainty and postpone decision making by consumers and businesses. This has, without question, contributed to slower U.S. economic growth.

Europe remains unsettled as well

• Hurricane Greece continued to spin, without much effect in July, but Hurricane Spain spun back up in a big way.
  • In early July, the Spanish banking system was found to be insolvent, and a hurried agreement was reached to recapitalize it.
    • Details were foggy, but its speed and size calmed markets.
    • As details became clearer, Spanish government bond yields spiked back above 7 percent.
    • By month-end, Mr. Draghi’s support for the euro calmed markets.
• Spain’s problems worsened and other countries disclosed worsening budget problems.
  • France announced measures to increase public spending and lower the retirement age—directly contrary to austerity demands made on other countries.
  • Germany’s economy seemed to be slowing, with political uncertainty growing.
    • Germany’s Constitutional Court announced that it would not rule on the latest rescue measures until September 12.
    • If the court rules against them, Spain’s rescue package could unravel.

Although perceived risk has decreased in Europe, the underlying problems are largely unsolved, and the risk may ratchet up again at any time.

A growing or slowing economy?

• Continued uncertainty is having a slowing effect on the U.S. economy.
  • Growth ticked down to a 1.5 percent annualized rate in the second quarter.
  • Weak by historical standards, it was slightly better than economists had feared.
• The quality of GDP growth wasn’t as good in the second quarter compared with the first.
  • Spending on durable goods weakened, indicating reduced consumer confidence.
  • Reduced government spending continued to be a drag in the second quarter.
• Job growth was at a relatively low level of 80,000.
• The ISM Manufacturing Index dropped to contractionary levels.
• Consumer confidence showed a drop at the start of the month.
  • Real consumer income continued to rise.
  • Retail spending declined for the third month in a row while the personal savings rate increased.
• Continued growth despite uncertainty described was encouraging.
  • In terms of employment, hours and average earnings increased.
    • Employers are increasing overtime for existing employees instead of hiring new workers—a trend that will lead to an increase in hiring.
  • The housing market continues to show signs of recovery.
    • On a seasonally adjusted basis, July showed the fourth monthly successive rise in prices, according to the Case-Shiller 20-City Home Price Index.
  • Other indices showed improvement as well, and the supply of houses for sale remained below historical levels.

Slow growth, but risks of “storms” remain

• The economy and markets proceeded cautiously in July.
  • Risks remain and should provide the basis for sustained short to intermediate-term volatility.
• While it is important to be aware of capital market risks, investors should also focus on investment strategies which are consistent their goals, and designed to perform well in volatile markets.
  • Investors should seek to match investment strategies to their goals, rather than let short-term concerns override long-term objectives.

Disclosure: Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets. All indices are unmanaged and investors cannot invest directly into an index. The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. The NASDAQ Composite Index measures the performance of all issues listed in the NASDAQ Stock Market, except for rights, warrants, units, and convertible debentures. The MSCI EAFE Index is a float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI Emerging Markets Index is a market capitalization-weighted index composed of companies representative of the market structure of 26 emerging market countries in Europe, Latin America, and the Pacific Basin. It excludes closed markets and those shares in otherwise free markets that are not purchasable by foreigners. The Barclays Capital Aggregate Bond Index is an unmanaged market value-weighted index representing securities that are SEC-registered, taxable, and dollar-denominated. It covers the U.S. investment-grade fixed-rate bond market, with index components for a combination of the Barclays Capital government and corporate securities, mortgage-backed pass-through securities, and asset-backed securities. The Barclays Capital U.S. Corporate High Yield Index covers the USD-denominated, non-investment-grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below.

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Sean Gross, CFP®, AIF®, is a financial advisor located at Telos Wealth Management, LLC, 385 E. Penny Rd., Suite 103, Wenatchee, WA. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network^®, Member FINRA/SIPC, a Registered Investment Adviser. Sean can be reached at 509-664-8844 or Info@TelosWealth.com.

Authored by Brad McMillan, vice president, chief investment officer, at Commonwealth Financial Network.

© 2012 Commonwealth Financial Network^®