In the first quarter of 2011, the stock market, as represented by the Standard & Poor’s 500 stock index, rallied 5.4% to close at 1326 on March 31 from 1258 at the end of last year. The benchmark ten-year US Treasury note saw its yield increase 14 basis points, or hundredths of a percentage point, to 3.45% from 3.31% on December 31, while the price of Gold increased 1.1% to $1438 per ounce from $1422 at the end of last year. Crude oil increased 35.4% to $107 per barrel from $79. Financial markets were buffeted from multiple directions during the quarter. Earnings and economic data were generally supportive of stocks, while the news out of the Middle East, Japan, and higher oil and commodity prices worried investors.
The market faces four immediate areas of concern moving into the second quarter. Most prominently in the headlines are the triple disasters in Japan. While the tragic events are dramatic from a humanitarian perspective, the long-term impact upon the global economy, let alone the profits of American business, will likely be limited. The impacted area represents only 1-2% of Japanese economic output. The situation in the Middle East is potentially more ominous. If political instability were to spread to the kingdom of Saudi Arabia, the impact on already elevated oil prices would be substantial. Oil priced above $120 per barrel (currently trading at $107 for the US benchmark West Texas Intermediate crude oil futures contract) on a sustained basis would significantly impact both global and domestic economic growth. Closer to home, the budget and debt ceiling battles in Washington could result in a shutdown of the Federal government. Such an outcome could shake confidence in America’s political leadership and negatively impact American markets.
Finally, uncertainty surrounds the expiration in June of the Federal Reserve’s second round of long-term asset purchases known as QE2. (QE is shorthand for quantitative easing.) It has injected approximately $100 billion per month into the markets by purchasing US treasury notes and bonds. If the purchase program is not extended, the loss of liquidity could have an adverse effect on US financial markets. We believe the condition of the labor market by the end of the second quarter will be the primary consideration in determining whether or not the Fed will continue with the program, although the Fed is not beyond being influenced by politics as well. Inflation will be a secondary factor. As of now, the conventional wisdom is that the program will be allowed to expire. We do not believe this has been fully discounted by the market, and could therefore be a source of weakness. While we believe the program will end in June, we do not rule out a QE3 further down the line if markets and the economy were to deteriorate.
Longer-term, three major concerns remain in place. The parlous fiscal condition of many states presents a significant risk to long-term economic growth. To close budget gaps, states will likely resort to austerity measures that will subtract from economic activity. In many cases, this process has already begun. The European sovereign debt crisis also remains. Peripheral countries like Greece, Ireland, and Portugal may ultimately be unable to repay their debts, and if so, the European banking system could be thrown into crisis. As Europe is our largest trading partner, this would have a significant impact on our economy and financial markets. Finally, perhaps the largest long-term risk is the financial health of the United States government. Given current projections, the US national debt will reach historically dangerous levels by the end of the decade. If America’s creditors lose confidence in America’s solvency, the economic and market repercussions would be severe. This is a threat that is still years out by our estimation, but it is a situation that we are monitoring closely.
Three factors predominate on the positive side of the ledger. First, the US economy undeniably has momentum. Tellingly, most economic statistics have consistently beaten the expectations of Wall Street economists. This is a phenomenon that typically has staying power and indicates sustained economic growth. We will become concerned when Wall Street expectations catch up with the actual economic data. In the meantime, the continued outperformance of the economy should support the US stock market. Secondly, the longstanding flow of money out of US equity mutual funds and into bond funds and emerging market equity funds has reversed. This has been a major underpinning to US share prices in the face of the concerns cited above. As with the economic growth story, this is a phenomenon that has legs. It is unlikely to reverse quickly absent a major dislocation in financial markets. Thirdly, and perhaps most importantly, large portions of the stock market are attractively valued. We are not finding it difficult in the current environment to find quality companies trading at discounts to our conservative estimations of fair value. Our experience has shown that the best long-term defense for a portfolio is owning cheap shares in solid enterprises.
For the remainder of 2011, we see the S&P 500 trading in a range of 1200 to 1425. It currently stands at 1326. Given the numerous worries present, we would not be surprised to see a retest of the 1250 level reached during the height of the Japan nuclear scare, in the months ahead. Longer-term, we expect to see the market continuing its advance for the reasons discussed above. Thank you for the trust you have placed with us. As always, feel free to contact us with any concerns you may have.