Third Quarter Commentary, 2009
By Robert Stimpson, CFA
Portfolio Manager
Mean Reversion and Looking Past the Noise
The third quarter of 2009 was another strong quarter for US stocks. The S&P 500 achieved its second consecutive double-digit gain, rising 15.6%. Market skeptics will dismiss the sharp gains as nothing more than an extension of the recoil rally from sharply depressed levels reached earlier in the year. After all, economic data remains bleak and fears of a dip back into recession persist. So, is the strong performance simply mean reversion, or are better days truly forthcoming?
Historically, the stock market does mean revert. Fickle investor psychology leads to periods of disdain or over-enthusiasm which produces excessively low or excessively high valuations. But longer-term, the indexes adjust toward a correct valuation. This assumption is crucial to modern portfolio theory. Anyone who witnessed the stock market excesses of the late 1990s and subsequent dot-com correction has experienced the market’s mean reversion tendency.
To dismiss the strong year-to-date performance as simple mean reversion perverts what the mean is. Certainly, recent manufacturing statistics and employment data remain weak, but it is clear that the economic situation is far improved from the depression-like forecasts that overwhelmed the stock market just nine months ago. The rise in stock prices is the result of a reassessment of the relative economic situation. Indeed the best-performing industries have been the most cyclical, confirming the improving economic environment. So where do we go from here?
Admittedly, recent ISM data and persistent unemployment figures have been poor. However, most economic data is a lagging indicator; while the stock market is one of the best leading indicators. As we approach the third-quarter earnings season, the improvements in investor sentiment will be echoed in corporate earnings reports. Expect a lot of “constructive” “encouraging” and “cautiously optimistic” comments that will perpetuate the self-fulfilling nature of the market.
Looking past the noise, the outlook for the US economy as a whole is much improved. Interest rates policies remain extremely accommodative and the current administration’s economic body language appears supportive. Indeed the faltering of larger policy initiatives seems to have helped the stock market, as major health care and environmental legislation would have been a large detractor to economic growth. While these initiatives will require continued monitoring, for the time being, the overall economic policies remain supportive and the checks and balances of the political system are functioning.
Structurally, the banking system has weathered the crisis, and formerly fragile financial institutions are sound once again. The commercial real estate indebtedness catastrophe that was predicted as the next wave of the crisis has not materialized. In fact, corporate real estate bonds are one of the best-performing asset classes this year. With the banking crisis averted, investors’ attention will refocus on earnings potential and relative valuation. This is a good thing.
Economic recoveries following financial crises can produce impressive stock market gains. This is due to the infrequent combination of multiple growth drivers. First, since stock prices are essentially the present value of future cash flows or earnings, once earnings growth returns it may help to drive stock prices higher. Second, earnings growth can be high following a recession due to cost-cutting and productivity improvements that act to leverage a company’s earnings power. Third, the valuation multiple that investors are willing to pay for financially strong, fast-growing or leading companies, may expand. The combination of better-than-expected earnings, leverage and higher valuation multiples may help to produce above average returns that can sometimes last for several quarters.
So while the year-to-date returns and back-to-back double-digit quarters are unusual, the outlook remains positive as the revaluation process and economic recovery typically last multiple quarters. The 2003 recovery is one recent example that is worth remembering.
This manager commentary represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice.
Past performance is no guarantee of future results. The S&P 500 Index is a market-value weighted index consisting of 500 stocks chosen for market size, liquidity, and industry group representation, with each stock’s weight in the index proportionate to its market value. You cannot invest directly in an index.