Third Quarter 2009

Review and Outlook

The market rally continued during the third quarter, with the S&P 500 tacking on a 15.6 percent gain. By quarter’s end the blue chip index stood almost 20 percent higher than it did at the beginning of the year. The strong market performance was again due to leadership from the financial sector, despite minimal improvement in underlying bank fundamentals. Also leading the charge were materials and industrial sectors that are exposed to the reignited growth of the developing world.

Surprisingly, even as the riskier equity markets rallied, bonds held their own. Typically, you’d expect investors to flee safer fixed-income investments in favor of a strong equity market – sending yields higher. That was not the case in the third quarter. The 10-year Treasury bond, for instance, saw its yield actually drop from 3.5 percent to 3.3 percent during the course of the quarter – suggesting that investors weren’t convinced of a sustainable stock rally, and continued to safeguard their portfolios.  

Given the underlying economic data, we can’t say we blame them. The employment picture continues to be an utter disaster. The unemployment rate, now at 9.8 percent, continues to rise – and is showing no signs of improvement. Factoring in part-time and discouraged workers, the underemployment rate actual sits at an abysmal 16.9 percent. Companies are simply not hiring, and the average workweek is now down to 33 hours – its lowest since records started being kept in the 1960s. Making matters worse, with such prolonged labor market weakness, unemployment insurance benefits are being exhausted by those searching for work (over half of those collecting benefits run out before they find a job – another all time high).  

Needless to say, job fears are taking their toll on the consumer. Contrary to expectations, confidence dropped in September from August, and spending – which accounts for more than two-thirds of our economy – is muted. The U.S. savings rate, while down from the 13-year high of 5.9 percent reached in May of this year, remains as high as it has been since the end of 2004. Oil prices have more than doubled off their lows, and continue to present a headwind for consumers and corporations alike – essentially acting as a tax on all economic activity (without any of the benefits of taxes).  

Led by Chairman Ben Bernanke, the Federal Reserve is pulling out all the stops to restart the US economy. The target Fed Funds rate remains close to zero, with rhetoric from the central bank to the effect that rates will remain there until the economy – and specifically the labor market – show signs of life. Further, the Fed continues to aggressively expand its balance sheet – buying Treasury issues on the open market in order to keep market rates low and help a still weak housing sector.  

We do expect the Fed’s actions, combined with inventory rebuilding, to initiate GDP growth over the coming quarter or two. However, these two factors won’t outweigh the worsening job market and higher resource prices that continue to stand in the way of sustainable economic growth.  

On the other side of the coin (or globe), growth has reemerged in earnest in the developing world. Stronger government controls over bank lending, as well as pointed spending and tax incentives have helped China to reignite its powerful economic engine – with a renewed focus on stimulating internal consumption (relying less on exports to the US and other developed countries). GDP growth is once again climbing towards double digits, as investments in infrastructure as well as heavy manufacturing (cars) are driving demand, and prices, for resources higher.  

As US companies push through earnings season with easier comparisons versus the year-ago period, we could see the market climb higher. However, in the absence of sustained revenue growth, cost-cutting and inventory controls will only help companies support earnings so much – and we expect the market to acknowledge this at some point. For our portfolios, we continue to invest in what we see as market leaders exposed to the pockets of real growth in both the domestic and global economies, while holding positions in gold and Treasury investments to protect portfolios in times of volatility.  

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