March 7, 2012
The stock rally paused in April with most stock indices ending the month near where they began. In April the S&P 500 was down 0.6% while the Dow Jones Industrial Average was up 0.2%. International and small cap stocks fared slightly worse than their domestic, large cap counterparts. The MSCI EAFE index was down 2.4% for the month and the Russell 2000 was down 1.5%.
Bond yields retreated during the month back to near historically low levels. The 10-year Treasury bond yield fell more than 10%, from 2.2% to 1.9%. Investors sought the safety of Treasury bonds as concerns over Europe’s debt problems resurfaced as well as renewed concerns of slowing worldwide economic growth. The Fed has indicated that they plan to keep short-term rates at current near-zero levels for the next couple of years. Inflation concerns are basically non-existent among economists, so long-term rates are also likely to stay low for quite some time.
Europe is expected to experience a shallow recession this year. The IMF is projecting -0.3% GDP growth for 2012. Although Greece has worked out a temporary solution for its debt problems, now Spain has taken over the headlines. Standard & Poor’s Ratings Services downgraded Spain’s credit rating two notches, and as a result, 16 Spanish banks were also downgraded. Because of the high cross correlation of European banks, the fear is that the broader European financial system will be affected.
Preliminary reports are estimating US GDP growth of 2.2% for the first quarter of 2012. This figure is lower than the 3% of last quarter and also lower than the consensus estimate of 2.5%. The fourth quarter figure included a build-up in inventories which may have become a drag on growth as consumer spending which was strong in February, was weaker and rose less than expected during March.
Fortunately, first quarter earnings have been favorable. In the S&P 500, 80% of companies who have reported earnings have beaten earnings estimates. Apple created a buzz when they reported blowout earnings that had nearly doubled from a year ago - the stock jumped 10% initially in response. Apple is the largest US company in terms of market cap, and its strong price movement has a significant impact on the returns of the S&P 500, NASDAQ Composite and other large cap stock indices.
Over the past four years, companies have been aggressively cutting costs. Profit margins are high for most companies as they continue to run lean during this recovery period. Earnings have grown because of these cost cutting measures and through revenue growth. Some companies did not have revenue growth but were still able to grow earnings just by cutting costs. Looking forward, for most companies to continue to grow their earnings, they will need to grow their revenues - there are few costs left that can be cut.
Earnings have also benefited indirectly by the falling dollar – the US dollar has depreciated 15% since the 2008 recession. About 35% of US corporate profits are from foreign sales; for large cap stocks in the S&P 500 the figure is even higher. When the dollar is falling relative to other currencies, it makes our goods cheaper. If the dollar were to reverse course and strengthen, it could create a headwind to revenue and earnings growth in the future.
More money has flowed out of stock funds and into bond funds consistently over the past three years even though stock returns have outpaced bond returns and forward looking bond fund returns are expected to be low and possibly negative. This movement reflects investor aversion to the inherent risk in stocks. Bond investments tend to provide some stability to a portfolio when stock prices decline.
(c) Cambridge Advisors