The RL Paler Quarterly Market Report July 2010

The stock market hit a wall in the second quarter after a 12 month bull rally, which saw the S&P 500 move from a March 2009 low of 666.09 to an April 2010 high of 1,219.80.  Additionally, The Dow Jones Industrials and the NASDAQ saw similar gains.

Then the bears saw an opportunity and sold off the markets.  From its peak the S&P 500 was at 1,219.80 and as of July 1 the S&P 500 stood at just 1010.91 dropping 17%.

It’s not a surprise, since during the second quarter we saw numerous negative headlines. There was a credit crisis in Europe, led by worries that Greece could default on their debt and defaults could spill over into other EU countries.

We also saw concerns about the global economic recovery with signs that China’s economy was slowing down, increased financial regulatory efforts, a massive oil spill in the Gulf of Mexico, and our own series of poor economic data (specifically in housing and employment).

All of these news items led some to question if the U.S. would experience a double-dip recession.  Which at this time, we do not believe will occur.

By the end of the quarter the indexes were in the red for the latest three months and erased their gains for the year.  The S&P 500 was off 7.0% for the half, the Dow was down 6.3%, and the NASDAQ fell 7.0% in the first half of the year.

Going forward, we do not see any quick cure for the economy.  We believe that employment will remain weak, which will translate into poor housing demand, low consumer spending and confidence.  Since consumer spending accounts for a majority of the U.S. GDP, we do not see any incentives for companies to begin hiring again.

With the challenges outlined, we believe that the second quarter GDP may have risen to 3%, but could fall back to 2% in the second half of the year.

Next up is the second quarter earnings season.  Over the past five quarters the S&P 500 has easily topped analysts’ consensus earnings estimates. We believe the trend will continue, with the second quarter being a good one with most companies topping estimates. 

There have been 71 negative preannouncements and 60 positive preannouncements going into earnings season.  The negative-to-positive ratio now stands at 1.2 compared to 1.3 in the first quarter, when 78% of the S&P 500 companies reported better than expected earnings. Current estimates are for the S&P 500 companies to report average earnings growth of 27% and for revenues to grow by 9%.

Wall Street will be watching current earnings reports, but future guidance will be the key for the markets future performance going into the third and fourth quarters.

Most believe that the market has priced in disappointing future guidance from companies.  This could set the stage for a rally, if companies give future guidance that meets or beats current estimates. Current estimates are for the S&P 500 to have third quarter earnings growth of 25.6% and 32.6% for the fourth quarter.

We believe that following the market’s recent setback, valuations are reasonable.  The earnings yield as of July 2, stands at 8.6%, compared to the 2.95% yield for the 10 year Treasury Note suggest that stocks are undervalued.

By no means are we suggesting that the second half of the year will be a cake walk.  Many of the issues that caused the decline in the second quarter still exist and future earnings guidance will be the key to a higher market.  Standard & Poor’s Investment Policy Committee, believes that the S&P 500 will advance 7.7% from the June 30 closing level.

Looking back in history, the market comebacks have often started after a series of setbacks.  As a long term investor, one needs to remain committed to their long term strategy, since that is what is needed to realize significant rewards over the long term.