Wednesday, July 7, 2010

Review of the Second Quarter 2010

As the quarter opened, optimism regarding the global economic recovery helped propel equity and commodity markets to post recession highs. The International Monetary Fund (IMF), for example, raised its forecast for 2010 global GDP growth from 3.8% to 4.2% and reiterated its prediction of 4.3% in 2011 (see our April 23 blog “Global Growth Accelerating”). Other elements of the positive case for stocks, including strong corporate earnings reports, very low inflation and interest rates, and assurances from the Federal Reserve that they would continue their accommodative policy for an extended period, also fueled the rally. For the Standard & Poor’s 500 Index, the high water mark was reached on April 23, at which point this benchmark had soared 79.9% since the beginning of the rally on March 9, 2009.
For the remainder of the quarter, global financial markets were buffeted by relentless negative headline news emanating mostly from Europe and the U.S. The major focus was on the debt problems of Greece, Portugal, Spain and several other Euro Area countries, which generated fears of sovereign defaults, a Euro Area banking crisis, and a retreat into recession as governments turned to austerity programs to redress their budgetary woes. Nightly reports of the rampaging BP oil spill in the Gulf of Mexico and scenes of suffering wildlife and crippled local businesses contributed to the gloomy mood. Another headache was the heightened tension between South and North Korea, which raised the specter of a military conflict that might involve nuclear weapons. The final blow was a disappointing U.S. employment report in early June which, coupled with discouraging housing and other economic data as the quarter drew to a close, pointed to at least a slowdown (and maybe something worse) in the U.S. economy.
The aggressive, speculative, and unregulated pursuit of short-term profit by U.S. and international hedge funds exacerbated the severity of the May and June decline in equity and commodity markets. Armed with powerful computers programmed to react almost instantaneously, often with leverage, to the latest news release or to shifting price and volume patterns in financial markets, the hedge funds’ high-frequency trading strategies created unnerving market volatility (see our May 24 blog “Global Financial Market Turmoil”). On one memorable early May afternoon, runaway computers unleashed, in 15 minutes of spellbinding shock, a 700 point intraday plunge in the Dow Jones Industrial Average, whereupon the market recovered the entire 700 points in the next hour. The jump in market volatility in May and June heightened investor anxiety, which then seemed to feed upon itself. As the financial media, in heated competition for ratings, fanned speculation of a double-dip recession and a new bear market, pessimism became fashionable. By the end of June, the long-term positive case for stocks, which had dominated markets in April and was still arguably relevant, was completely eclipsed.
Another consequence of the computer-driven, hedge-fund trading during the quarter was the inter-connectedness of global equity, commodity, bond, and currency markets. An event in one country could quickly cause a chain reaction around the world. For example, each new indication of debt problems in Greece or Spain triggered a jump in these countries’ bond yields and declines in the euro and European stock markets, which led to an immediate rise in the U.S. dollar and U.S. Treasury prices and a plunge in U.S. stock prices, which prompted a decline in commodity prices and a selloff of stocks in the leading emerging economies of China, India, and Brazil. U.S. investors were forced to recognize that global economies and financial markets had become so intertwined that seemingly obscure events in far off places could profoundly impact U.S. stock and bond prices.
The Standard & Poor’s 500 Index slumped -11.9% for the quarter, and the EFA Developed Countries ETF, which consists primarily of Europe and Japan, plummeted -16.9%. The EEM Emerging Economies ETF declined -11.4% despite booming economic growth and healthy financial institutions in China, India, and Brazil. Also on the losing side was the CRB Index of commodity prices, which fell -5.4% paced by a -8.1% slump in oil prices. A notable winner was the U.S. dollar, which traded inversely to the U.S. stock market and rose 6.1% against a basketful of currencies. A flight to safety by risk-averse investors was especially beneficial to the perceived safe havens of gold and U.S. Treasury notes and bonds. Gold tracked the rise of the U.S. dollar (and decoupled from other commodities) as its price soared from $1115/ounce to $1244/ounce. The yield on the benchmark 10-year U.S. Treasury note dove from 3.83% to 2.94%, while its European safe-haven counterpart, the 10-year German government bond, fell to 2.59%.
Within the S&P 500 Index, 7 of the 10 industry sectors, representing 88% of the Index, posted declines ranging from -10.1% to -14.5%, and all 10 sectors had negative returns. The largest setbacks were in the economy-sensitive energy (-14.5%), consumer discretion (-14.0%), and materials (-13.2%), whereas the least impacted were the recession-resistant sectors of telecommunications (-0.5%), utilities (-5.3%), and consumer staple (-6.2%). Many individual stocks suffered plunges: 97 stocks were off 20% or more, and 24 of these stocks plummeted 30% or more. Size did not offer safety: the 23 largest companies (those with market capitalizations in excess of $100 billion), recorded an average loss of -12.3%. Apart from the S&P 500 Index, the Dow Jones Industrials were down -10.0%, the Russell 2000 Index of small company stocks shed -10.2%, and the NASDAQ Composite (mostly technology stocks) retreated -12.0%. Of the 24 international country ETFs we monitor closely, 19 were down more than -10.0%, 4 of the leading emerging economies (China, Hong Kong, India, and Singapore) fell single digits, and 1 (Chile) managed a 3.2% gain. There were few places to hide in either the U.S. or international stock markets.
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