At this half way point in the year the market is pausing—looking not only at where it has been but how far it has to go. From the March 9 low to a high in mid-June the S&P 500 rallied about 40% yet was still about 40% off the high set October 9, 2007. For the balance of June and into July the market has wavered. While the economic decline appears to be slowing we’re lacking convincing evidence that the economy has turned. Additionally, earnings season is upon us and investors are looking for affirmation that corporate profits justify the current valuations.

At the beginning of the quarter we had already experienced a three week, 20% off-the-bottom rally. As the quarter continued the largest pull back in the major averages was less than 4%. While financials was the best performing sector for the quarter it wasn’t necessarily based on strong fundamentals but on the belief that the financial system would indeed hold together. The main driver was the premise a global economic recovery will be led by emerging markets. These economies will have energy and material needs which drove up the stock prices of companies in those sectors. In addition, technology has been a strong leader on the premise companies around the globe will turn to technology to boost productivity. In fact the Nasdaq gained 20% in the quarter and is up 16% for the year while the S&P 500 is up 3%. And, international investments that emphasized emerging markets outperformed—China’s Shanghai index gained 25% for instance.

The strength and resilience of the rally also coaxed investors from the safety of Treasuries leading that asset class to a 3% decline for the quarter and a 4% loss for the first half of the year according to the Merrill Lynch Treasury Master index. While some of that money undoubtedly drove stock prices, it also moved into investment grade bonds which were up nearly 11% for the quarter while high yield bonds gained 23% according to Merrill indexes.

The question now seems to be whether markets have gone too far, too fast. The economic challenges are daunting: the housing industry has slowed the rate of decline but not yet reversed course, unemployment continues to rise and is commonly expected to reach double digits, consumer sentiment is negative and the deleveraging process for companies and individuals is painful, leading to larger numbers of bankruptcies.

Those who look through the current statistics and try to anticipate the next phase of the economy are more optimistic and point to economists who think the recession may end in the third quarter. But few think there will be a robust recovery and both bulls and bears agree it’s going to be more difficult for the market from here. The strength of earnings to be released over the coming weeks is going to be important for the rally to continue. Consequently with these cross currents at the mid-point of the year we anticipate some choppiness in the market.
While we at CFSI are aware this will be a difficult recession to recover from we know there can be strong rallies—that perhaps can be called bull markets—while the economy is improving. As such, we have tilted portfolios toward the areas experiencing the most gains. In the bond portion of the portfolio we added an ‘opportunistic’ category with high yield and emerging market bond funds. The ‘core’ part of the bond portfolio has emphasized investment grade bonds and we sold any treasury positions. In all of our corporate bond positions we have realized equity-like returns without increasing our stock allocation.

In the international equity portion of the portfolio the emerging market allocation either equals or exceeds the more diversified international fund allocation. We have added small cap growth and changed our mid cap growth investment to better capitalize on other trends we prefer: small cap over large cap and growth over value. We have also added a Nasdaq/technology position in the specialty portion of the portfolio.

We feel the trends that have been profitable so far this year to a large extent will continue to be profitable the balance of the year with a few caveats. We anticipate more of the return in the high yield funds will come from income rather than capital appreciation but we’ll continue to hold those positions. While technology is usually a leader in the early stage in the cycle it typically yields its leadership position to other groups when we move into the next phase of the rally. That may not be the case this time but we are watching that position with the possibility for a change during the second half of the year. In addition we feel the emerging economies and markets in the Pacific region and Latin America have greater potential than developed markets and we are inclined to add to that portion of the portfolios.

In most cases we have some cash to be invested when opportunities present themselves. And, on the flip side, we are always evaluating new data and market activity and if new information or trends develop that challenge those underlying assumptions we will change course.

[back to articles]
[back to newsletter archives]