The Market - Economic Review First Quarter 2010
Given that we are now one year from the market lows of last March 9th, it’s useful to look at the first quarter of 2010 in light of the market’s progress in the last twelve months.
For the quarter, the major indices logged solid gains, with the S&P 500 up 5.4% and the Nasdaq Composite up 5.9%.1 The quarter continued to add to what was already one of the strongest cyclical bull markets in history, with the S&P 500 75% higher and the Nasdaq 84% higher than their lows of a year ago. Despite this run, however, the markets remain well off their secular highs achieved in the last decade, with the Nasdaq still 54% off its 2000 high.
There are many indications that the recovery which began in the latter part of 2009 continues. According to the Financial Times, “economists are predicting the U.S. economy will see a surge of new jobs [in March], with some 300,000 positions being created after a loss of about 8.4 million jobs during the recession.” 2 The Federal Reserve statement that business spending on equipment and software had “risen significantly” 3 and its reiteration that interest rates would be kept low for an “extended period” 4 were also encouraging.
But there are several economic factors that may weigh on the recovery. Even with the modest job growth predicted for March, unemployment remains very high. Household spending continues to be constrained by flat income growth and tight credit, and this will likely affect retail sales as consumers remain cautious. Meanwhile the housing market still sits at record lows. Sales of new single-family homes in the U.S. declined a seasonally adjusted 11.2% in January, which represents the lowest sales pace since these records began in 1963.
There are also two larger trends, one historical and the other demographic, that may affect market returns going forward.
Cyclical Bull Market Trends. According to Ned Davis Research, the median gain of the S&P 500 in the first year of a cyclical bull market is 29% but the second year sees only 9% growth. Small cap and lower quality stocks, which tend to lead the broader market during periods of recovery, tend to give ground as recoveries mature into their second year.5 With the first year of the current cyclical bull market experiencing torrid gains, which is in line with this historical trend, many analysts are expecting to see this year’s returns also follow the trend and come in below last year’s while still remaining positive. Ned Davis Research believes there is still a good chance the markets could experience a drawn out correction in the second and third quarter, bringing the overall gain for the two years to be more in line with historical averages.
Inflows to Bond Funds. As mentioned in The Wall Street Journal, The Investment Company Institute reported that long-term mutual funds had net inflows for 52 weeks in a row as of March 18, a shift in assets totaling some $506.6 billion. Certainly some of this inflow represents money returning to the market in the wake of recent gains. But the bulk of investment in 2009 was in bond funds, which accounted for $409 billion of the net inflows.
This reveals an interesting demographic trend that may also have implications for market growth in the coming months and years. As baby-boomers enter retirement, they tend to allocate a greater share of their portfolios to fixed income securities. As the Journal goes on to report, another factor at work in this trend, “is a dip in risk tolerance. Investors, who have seen steep losses in two bear markets, have lost some of their appetite for risky investments. Additionally, the rising use of automatic asset allocation, which moves investments toward fixed income as investors age, is driving inflows to bond funds.”
This suggests that older investors may be less likely to invest in equities even if the broader recovery proves strong. With so much money remaining on the sidelines, the massive inflows to equities that some predict may not materialize. Lower-than-expected inflows would likely have a dampening effect on equity prices. However, the broader inflow trend is definitely positive.
Predicting which of the above factors will most influence the market is difficult. The market may present opportunities, but it also contains risk. Investors may want to proceed with caution and diligence.
1All returns sourced from Morningstar.com and Bloomberg Finance L.P.
2“Outlook for US economy upgraded,” Financial Times, March 17, 2010
3ibid
4ibid
5Chart of
the Day, March 9, 2010, Ned Davis Research, Inc.
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