Market Commentary: Third Quarter 2012

The Stock Market Closes a Strong Third Quarter

With the help of considerable amounts of central bank accommodation, stocks finished the third quarter higher.  The S&P 500 climbed 5.7 percent over the past three months and finished the quarter up over 14.5 percent year-to-date.

The balance between fear and fundamentals has shifted thus far in 2012. Investors are starting to focus on fundamentals once again as the fear that clouded the markets in 2011 continues to dissipate.  Even with the equity rally this year, stock valuations remain attractive.  When we consider a variety of valuation metrics, such as price to book, price to forward earnings and price to cash flows, stocks appear inexpensive relative to their long-term averages.

However, future earnings growth will be dependent on revenue growth, as companies have drastically cut costs and will now have to rely on margins to drive earnings.

U.S. Economic Data Helps Boost Markets in 2012

Despite a number of headwinds, the economic recovery is now three years old.   Although the level of economic growth has been moderate, the economy looks set to continue to expand in the fourth quarter.  Housing and corporate profits continue to improve while the unemployment picture shows very little progress.

The housing recovery is gaining steam – which is a good sign for the economy heading into 2013. Sales of existing homes jumped 8% in August — an annual pace of 4.8 million, the strongest since May 2010. The stronger sales are resulting in higher home prices, which are helping the economy as a whole. By year-end, sales will likely total over 4.5 million, up 7% from the 2011 figure.

Housing starts rose a healthy 2.3% in August. But that pace is still just 705,000 annualized, a far cry from the normal pace of slightly more than 1 million a year before both the recent bust and the preceding boom.

Unemployment continues to make only modest improvements.  The U.S. is likely to add fewer jobs this year than last — about 1.6 million, compared with 1.8 million in 2011. The economy added a meager 96,000 net new jobs in August. The slow pace means hiring won’t put much of a dent in the unemployment rate which was 8.1% in August.

In fact, more setbacks are possible this fall, as the so-called “fiscal cliff” approaches and private employers’ confidence in the government’s ability to avert this calamity is low. If Washington fails to hammer out a deal to avoid the scheduled tax hikes and huge automatic federal spending cuts scheduled to start in January, the economy could fall into recession. Indeed, just the fear of no resolution will dampen hiring in the near term.

Europe Continues to Make Strides

The biggest stride forward in the European debt crisis occurred this year with the election of the new president of the European Central Bank, Mario Draghi. He opened the bank’s coffers on easy terms to the continent’s banks, giving them breathing room; lowered the interest rate his inflation-hawk predecessor had raised and convinced Europe’s leaders to back an eventual move to a continent-wide system of deposit insurance and bank oversight to help prevent bank runs.

Mr. Draghi’s boldest move, in September, was to outline a framework for unlimited purchases of the bonds of troubled Eurozone countries to stabilize the interest rates threatening the solvency of Spain and Italy, effectively putting itself in the position of lender of last resort long played by the Federal Reserve. That would in effect make the Eurozone as a whole responsible for some individual countries’ debts, an idea Germany had long resisted.

The challenge for Europe is to keep Italy and Spain from ending up like Greece and Portugal, whose borrowing costs rose so high in 2011 that it signaled real likelihood of default, making it impossible for the governments to find buyers for their debt. Since then, Greece and Portugal have been reliant on the financial backing of the European Union and the International Monetary Fund.

Redline Drawn in Israel/Iran Tensions

Perhaps one major threat to the global recovery is the increasing tensions between Israel and Iran.  Israeli Prime Minister Netanyahu has proposed a bold step to “draw an official line” for Iran’s nuclear development.  This calmed the fear of an immediate military strike by Israel in the short term but it does not resolve the fact that Iran will eventually produce a nuclear weapon if things continue as they have.  The U.S. President and other global leaders will need to develop a definitive plan for Iran by early 2013.  The markets will most likely be able to remain calm over this issue for the remainder of this year and we will monitor these developments closely in 2013.

Although equities have nearly doubled since their March 2009 lows, stocks still appear attractive relative to history on a variety of valuation metrics, and are especially cheap compared to bonds.   Job growth and political uncertainty remain key areas of concern going forward.  However, pent-up demand in key cyclical areas (housing, autos, capital expenditures), accommodative monetary policies globally and impressive results from the corporate sector could drive growth into 2013.