Summer Roller Coaster
Summer is a time when many Americans seek out amusement parks for the thrills of riding a roller coaster. The climbs and drops at high speed deliver an exciting mix of fear and exhilaration. But knowing the extent of the highs and lows and when it is going to be over play a crucial role in the fun of riding a metal roller coaster. Riding a market roller coaster offers no such assurances and is no fun at all.
To say last week was volatile for the markets would be a major understatement. The stock market posted one of its most volatile weeks ever with swings of greater than 4% during each of the first four days of the week, changing direction with each day. This pattern of performance has never before been seen in the 83-year history of the S&P 500 index. By Friday, stock market turbulence slowed. For the week, the S&P 500 was down 1.6% adding to the losses that now total 13% since the recent peak on July 7.
While the U.S. debt downgrade in the week before last grabbed a lot of attention and added to the lingering pessimism heading into last week, one of the primary drivers of last week’s volatility was that eurozone leaders, while making some successful efforts, have not gone far enough to resolve the debt problems in the eurozone. Investors feared a downgrade to France, and another banking crisis stemming from some French banks noted by Moody’s,as at risk of a downgrade due to their exposure to troubled debt. Another key driver was the better-than-expected economic data on retail sales and the labor market along with the Fed confirming they intend to keep short-term interest rates low until mid-2013. This optimism that the U.S. economic softspot was firming vied with the concern that the pace of economic growth in the United States may soften further as stimulus begins to fade.
While last week’s volatility is unprecedented, we can take some comfort that the overall moves and sentiment in the market this summer are familiar; they echo those of last summer.
- At the low point of last week, the S&P 500 was down 17%, similar to last summer’s volatile 16% peak-to-trough decline.
- The 10-year Treasury note yield has fallen 1.6 percentage points from the high of the year, similar to last summer’s 1.6 percentage point decline from the high of the year.
- The drivers of the decline are similar to last summer, as well. Last year, Europe’s debt problems were a main cause of the market’s decline, as was an economic soft spot in the United States as stimulus began to fade when the Federal Reserve ended the QE1 bond buying program andstate and local governments were cutting back on spending.
So, maybe we have been on this market roller coaster before, and, if so, we might be near the end. Last year, the roller coaster did not leave the track and the summer plunge turned into a steep climb as stock and bond yields rose to new post-recession highs. We continue to believe this summer’s drop will end with similar results and ultimately produce a modest single-digit gain for the S&P 500 in 2011. We believe the fundamental underpinnings of solid corporate earnings growth (up 19% year-over-year in the second quarter), low valuations (the price-to-earnings ratio fell to levels not seen since 1989 during the lows of last week), and firming economic data (as Japan’s economy rebounds from recession) will combine to support stocks, high-yield bonds, and other business cycle-sensitive investments.
