April 2010 - Commentary: Bull Market Celebrates its First Anniversary as the Economic Recovery Gains Strength

The global equity and credit markets extended their rally during the first quarter against a backdrop of accelerating economic growth, benign inflation and low interest rates. A modest mid-quarter sell-off amid heightened global uncertainty as well as a host of domestic issues failed to derail the best start to the year in over a decade. As investors reflect on a solid quarter and the bull market celebrates its first anniversary, it’s worth reflecting on the difference a year can make in the financial markets.

The broad S&P500 stock index rose 4.9% during the quarter but remains 25% below its all-time high in October of 2007. Internationally, the markets were more subdued against the backdrop of the sovereign debt concerns in Europe and the tighter monetary policy moves in China. European stock markets lagged U.S. returns while Chinese stock markets actually ended the quarter lower. As a direct beneficiary of the global economic recovery, Japanese stocks were the exception, outperforming the S&P500 slightly. Finally, commodity prices, which are closely linked with the economic ups and downs of the emerging markets, were appropriately mixed given these conditions.

The quarter was a choppy one. The mid-quarter selloff resulted in an 8% correction for the S&P500, marking the third, classic back-and-fill 5-10% correction since the bull market began a year ago. Markets were rattled intra-quarter as China took steps to cool its double digit GDP growth rate and its accelerating inflationary threat. Specifically targeting their rapidly rising housing prices, Chinese authorities tightened bank lending standards on several occasions. Meanwhile, a historically staid Europe burst on the global scene as fiscal concerns around large budget deficits, subdued economic growth prospects, and widening borrowing costs created concerns over a potential debt crisis for several countries in the European Union. With investors’ memories still jarred by the Lehman Brother’s bankruptcy in September 2008, questions over the risk of a growing debt crisis across Europe led to a rapid shift by investors to lower risk investments. These issues, along with political developments in Washington, including the healthcare debate as well as punitive bank regulatory actions, sparked the modest correction. As investors quantified the impact of these risks, it became clear that neither could derail the global economic recovery at this juncture and stocks resumed their upward trajectory.
 

Despite the improving headlines trumpeting the strengthening recovery, we continue to worry about the housing and employment markets, which remain obstacles to this country’s economic potential.

The housing market by contrast has shown little to no recovery beyond stabilization in recent months. While affordability is improving (mortgage rates are low and prices stabilizing), inventories continue to rise, foreclosures are substantial, and the government subsidy programs have come to a close. We are closely watching the Spring selling season but our expectations are guarded at best. Rather we see a multi-year inventory work-out as a necessary step before recovery can set in. Additionally, the housing market recovery can only follow an employment market recovery – which we acknowledge is likely to be subdued.

In spite of these headwinds and the global trials we experienced this quarter, the economic recovery continues to gain momentum a year into this bull market. Our outlook remains for a moderate but sustained economic recovery with a benign inflationary backdrop. Broadly speaking, we believe we are at the beginning of a multi-year cyclical recovery tempered by the excesses of the last cycle as much of the destructive leverage is wrung out of the system. Economic models predict that a 5-6% GDP growth rate would be the norm after experiencing such a significant economic contraction, but with the structural issues in the housing and employment markets, economic growth will likely be lower than the norm: a 3-4% rate in 2010. Barring some unforeseen geopolitical shock or significant policy error, a double-dip recession seems unlikely.

We are optimistic about the near-term prospects for the market and believe this business expansion will be increasingly self-sustaining throughout the year. Meanwhile, we will be closely monitoring housing and employment trends, the likely unsynchronized global tightening of monetary policy, sovereign debt concerns, the pace of economic recovery, and inflationary trends as we manage risk in your portfolio.

As we reflect on the past 12 months, there are no words to adequately capture the historic period we have just weathered. Now more than ever, maintaining a balanced portfolio that is diversified globally across asset classes, while strategically and tactically rebalancing as opportunities present themselves, is critical to investment success. We are pleased to be able to report to you on this 1st anniversary of the bull market and our 28th year as a firm, that Sand Hill Global Advisors has emerged stronger because of our convictions throughout the cycle. We remain committed to providing you with the superior service and financial advice that today’s complicated market environment requires.

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