Investment returns were solidly negative in the second quarter. The European debt crisis and uncertainties about the pace of economic recovery were the main catalysts for the drop in valuation.
The returns in the fixed-income sector mirrored investors’ risk appetites. Treasuries enjoyed significant appreciation, as illustrated by the second quarter return of nearly 15% in the iShares Barclays 20+ year Treasury ETF (TLT). Meanwhile, most global and corporate bond positions underperformed the Barclays Aggregate Bond Index.
Last quarter’s pullback in stock prices puts the major indices down in the high single-digits for 2010. Industry pundits differ as to whether this retreat is a buying opportunity or the first sign of a market top. There are several reasons why we think the former is a more likely scenario.
First, corporate earnings continue to sparkle. Profit margins of the S&P 500 companies were 36% in the second quarter–the highest in recent memory, and even greater than the 30% margins posted during the Reagan era. It seems obvious to us that large companies are well managed, well capitalized, and should deliver impressive after-inflation returns in the next market cycle.
Second, there is now little doubt that the low interest-rate environment we are in will continue in the foreseeable future. The renewed commitment by central banks to maintain policy accommodation through 2011, combined with the positive cyclical momentum makes a double-dip recession a highly unlikely event, in our view. We see the encouraging announcement from China that they would let their currency steadily appreciate as a meaningful sign that their economy is strong enough to handle a slight tightening and that its growth can be shared with the rest of the world. It is also worth noting that recent European data, the weakest link of the global economy, have mostly surprised on the upside.
The recent drubbing of European stocks represents an area of investment that is becoming increasingly more attractive. Euro zone equities boast a price/earnings multiple roughly 20% lower that of the U.S. Continued depreciation of the Euro currency will likely boost exports in that region. Productivity should also rise, as benefits are being reduced and retirement ages go higher. Austerity is never a pleasant mindset, but in the long run can work wonders on a country’s balance sheet. History has shown that belt-tightening nations can significantly benefit from lower currency valuations, resulting in reduced domestic consumption and higher exports. It would be a historical anomaly if Europe did not eventually experience a recovery of this type.
As investors scramble to preserve capital, bond returns are exceeding stock gains by the widest margin in nearly a decade. Most of the outperformance can be explained by the eye-popping returns of the Treasury market, especially on the longer end of the maturity range. The short end of the curve has also been strong, as two-year Treasuries yields hit their lowest level on record. Although there are still opportunities in the corporate bond arena, we feel that the profit potential in equities has become more compelling than that for bonds at this point in the cycle.
Ben Warwick is chief investment officer of Quantitative Equity Strategies LLC in Denver.
See more of Ben Warwick’s Portfolio Gourmet blog posts:
Sovereign Debt and Asset Allocation March 30, 2010 We’re facing extraordinarily high levels of government debt, but GDP growth is moderate at best. Are we facing disaster? …
Economic Briefs March 01, 2010 Sure, equities have had a nice run. But it may not be time to trim, yet….
Large Cap Logic February 09, 2010 Investors will flock to U.S. large-cap companies, especially those with sound dividends, while small company stocks will remain relatively unloved….
Hedge Funds Buy Equities December 09, 2009 The stock market’s impressive gains have been criticized by many as the result of easy money and speculation. But as index levels continue to rise, increasing numbers of investors have joined the buying frenzy…
A Closer Look at the Housing Numbers November 24, 2009 Like most pragmatic folks, I’m used to the divergence between perception and reality. But when the numbers and the intent fail to confirm one another, the skeptic in me tends to surface….
Why Have Large Caps Outperformed Since August? November 19, 2009 Three themes help explain why that’s happening…
A Steady Course November 05, 2009 Even though stocks have dropped a bit lately, there are reasons to be a little more optimistic….