10/3/2009 - Third Quarter 2009 - What a difference a year makes

In preparation for this quarterly letter, after compiling and reviewing the relevant benchmark data we usually read our own market commentary dated from the prior year. Wow! The third quarter 2008 letter was pretty depressing. It could not get any worse, but in hindsight we know that it did! How did we all survive? The world markets were basically in free fall during the first and second weeks of October 2008.The DJIA had lost nearly 1,900 points in the first full week of October trading alone. Everything changed when Lehman Brothers failed in September 2008. The credit crisis was on.

A year ago this time, the world financial “perfect storm” was in full fury. The S&P 500 would end October 2008 at 969. Could anyone predict or fathom that it would fall another 31% from there and bottom on March 5, 2009 at 666, only to sharply rebound 58% to end September 2009 at 1,057. (The S&P 500 ended last September 2008 at 1,165).  Needless to say it has been a very interesting and volatile12 months.

The 3rd quarter 2009 was the best quarter for equities since the fourth quarter of 1998. All major indices enjoyed quarterly returns of at least 15%. It was the best third quarter since 1939. Financial and material stocks were the best performers. Emerging and international markets outperformed by an additional 4% to 5%.

The bond market was resurgent as well with large quarterly gains across the board. The municipal bond market rallied nearly 7% alone. Predictably, the United States treasury market is the only fixed income component in the red for the year. Interestingly, TIPS rallied hard in the 3rd quarter (plus 3%) and are now up 9.5% year to date for the nine months ended September 30, 2009.

Key Rates
Prime rate remains at 3.25%. and the discount rate is .50%. The ten year Treasury note and thirty year Treasury bond yield 3.30% and 4.04%, respectively.

Commodity update
Gold ended the quarter up at $1,008 per ounce and oil at $70.61 per barrel. Natural gas rose sharply after bottoming to a seven year low just after Labor Day.

What will happen over the next few quarters?  The opposing view points are as follows:

A bull case
One year ago the Fidelity money market yield was a respectable 2.6%.  Today, near zero rate risk free returns are unattractive and unacceptable to most investors. Yes, the stock market is expensive on a price to earnings basis; however dividend paying equities still yield in many cases more than 2.5%. Housing prices in most areas have stopped declining. Major stimulus spending (although approved) has yet to work its way into the economy. Unemployment is admittedly high, but the job loss on a month over month basis is decreasing and unemployment is a lagging indicator. 

Technically, due to mean revision (picture a bell curve) the stock market was oversold on the downside. It is only natural that it overshoots on the upside in order to revert to average historical norms. Besides, hedge funds and many mutual fund portfolio managers in many cases are currently lagging the market badly. Expect a 4th quarter rally with a lot of window dressing chasing returns, in the process pushing the indexes to new heights. Most tax loss selling occurred in the first quarter this year. The recent rebound in most global commodity prices (except agriculture) are evidence that the emerging economies will ultimately drive the world recovery.

A bear case
Unemployment is approaching 10% nationwide. The average consumer is tapped out and is saving whatever little extra money is available. Reported quarterly earnings are for the most part exceeding estimates based upon last years huge write downs and aggressive cost-cutting, enabling extremely favorable comparisons.  Very few of the earnings surprises this past quarter came from top-line revenue growth.

The rebound in the world economy is artificial and manufactured by governments. Once the medication (ie. stimulus and tax credits) is withdrawn from the patient (the US economy) will swoon even further. The recovery lacks any organic growth. The US deficit is exploding and the next shoe to drop will be in the commercial real estate market when owners try to refinance properties with fewer tenants and evaporated market values.

Two conflicting points of view with regards to the world market outlook clearly exist, both containing compelling arguments for and against future growth and recovery. No one can really predict with any certainty what lies ahead. However, we do feel somewhat vindicated in that a diversified portfolio has rebounded positively over the past six months and now has double digit returns year-to-date.  While future returns are by no ways guaranteed, an astute investor should come to the realization that one cannot time the market and that a balanced approach is the best long term strategy to build and preserve wealth. That is how we survived.

  Respectfully submitted,
   
                                                          CRA FINANCIAL, LLC