Market Outlook: 2010 Mid-Year Commentary

The Economy

There is only one economic figure that matters now – employment.  Typical of most economic recoveries, jobs are stubbornly slow to return.  The domestic forces that create inflation and those that spawn deflation stand ready to battle for center stage, waiting for their cue from the emergence of jobs.  Politicians in Washington, D.C. have front row seats to this epic economic drama.  They don’t need polls and expert strategists to realize that 10% unemployment won’t lead to re-election.

Meanwhile, U.S. Gross Domestic Product (GDP) rate of growth has been low but positive so far in 2010.  Annualized growth needs to consistently top 3%, however, for jobs to blossom and take root.  That rate has not been achieved yet, leading many to question the traction this recovery has from the grips of this deep, long recession.  Clearly, the stage has been set with plenty of monetary and economic stimulus.  Now we sit tight, waiting for jobs to make a grand entrance.

The Markets

Investors are not buying the good news.  While strong corporate earnings growth coupled with low interest rates and subdued inflation are usually main ingredients for prosperous markets, investors remain very skittish about the potential for the economy to drift into the everlasting doldrums.  Prevailing wisdom concludes that the U.S. and Europe will struggle to grow their economies again, while places like China, India and Brazil will carry the torch for capitalism.

Stocks

Earnings growth for the first half of the year was strong compared to a year ago.  However, it was hardly enough to settle the stomachs of anxious stock investors.  The S&P 500 Index was down more than 6% for the first six months of 2010.  Caught in a climate of tepid economic growth, many industries struggle to raise sales. As a result, companies manufactured earnings growth via expense reductions.  At the dawn of this potentially deflationary era, corporations face tremendous pricing pressure for their products and services.  Stocks prices reflect this investor sentiment.  Today, stocks are priced as if the economy will grow at about half the pace of the past decades.   Meanwhile the average dividend yield of the companies in the S&P 500 Index is approaching the same level as the 10-year U.S. Treasury Note.  Clearly, investors have very little faith in the ability of large U.S. companies to grow their businesses.

Bonds

Treasury yields keep finding new lows.  Concerns about slow economic growth, deflation and currency instability, convince market makers that no yield is too low to secure preservation of risk-free capital.  Holders of long-term bonds benefited the most from the further erosion of interest rates.  Surely only short term traders would be interested in buying long-term bonds at such low yields as 4% for a 30 year bond.  Could the prospects for future economic growth of the U.S. be so poor to warrant such a price?  We can only hope not.

Commodity Futures

In general, commodity prices in 2010 continued to foreshadow deflation, or at least a sputtering economy.  The S&P Goldman Sachs Commodity Index was down about 11% for the first six months of 2010.  Prices of all types of commodities are lower so far this year, except for livestock and precious metals (gold prices are generally a poor indicator of commodity demand since they march more to the cadence of currency instability rather than economic demand).   Commodities values often stretch higher once an economy is in a prolonged growth pattern during which time these limited resources are in high demand.  The U.S. economy seems years away from that stage.

Real Estate

Location has never been more important in the real estate markets.  Where occupancy rates remain relatively healthy, commercial properties are holding their value.  Housing markets are stronger in areas where unemployment is lower and where new housing development is limited.  The National Association of Real Estate Investment Trusts (REIT) Index was up more than 5% for the first half of 2010.  REITs have been able to tap the public markets for capital by issuing new shares of stock.  Access to capital has greatly relieved the liquidity pressure for many public real estate companies.  While average yields for REITs have come down, they are still attractive to yield starved investors.  The average dividend is about 4.5%.