Saturday, May 30, 2009

May2009: Summary of Developments Relevant to Investment Decisions

This post will be part of an ongoing series. The primary objective is to take a step back from daily market gyrations and the noise created by the constant barrage of headlines, and objectively assess the major developments of the month.

US Equity Markets
The major stock indices continued their impressive rally which began on March 9th, albeit at a more constrained rate of increase than in March or April. The S&P500 began the month at 872.81, and ended at 919.14- an increase of 46.33 points or 5.3%. This corresponds to to an annualized rate of increase of 86%, which is likely unsustainable.

US Treasury Market
The most profound development in the market for US Government debt occurred at the 10-Year portion of the curve. The yield on the 10-Year note began the month at 3.1%. By the midpoint of the month, the yield was little changed. However, from May 20th to May 27th, the yield on the 10-Year increased by nearly 50 basis points to a month-high of ~3.7%. A variety of justifications have been offered by the investment community concerning the underlying causes of the downward price pressure. We reside firmly in the camp that sees the movements as the Market's skepticism towards the ability of the United States to service vast amounts of newly acquired debt. We expect this trend to continue until the Fed decides to step in and defend the 10-Year. We do not know the exact point that this will occur, but we suspect that the Fed will be loathe to allow the 10-Year to push average mortgage rates into the 6% territory. There are several planned Treasury auctions in early June- the outcome of which will likely dictate future Fed actions in the arena of quantitative easing.

Geopolitical Developments
North Korea: The isolated dictatorship has continued to test the Obama Administration's willingness to forcibly curtail its nuclear ambitions. At some point, China is likely to exert its influence over North Korea and compel the "Great Leader" to cease and desist. It is in China's interest to allow this chirade to continue at the moment, because it highlights Washington's relative inability to exert power over the region. However, North Korean actions that could potentially stymie a global recovery and induce world panic are certainly not in China's interest. That being said, further escalations of rhetoric between Washington and Pyongyang could have the effect of provoking short term volatility spikes in US and other equity markets.

Pakistan: The Pakistani army's advancement into the Swat Valley has continued to displace residents, creating a humanitarian nightmare. Recent pronouncements from the US military indicate that the Obama Administration is laying the necessary groundwork to justify a military intervention in Pakistan. We expect that this will not occur, as the Pakistani military is fully capable of extinguishing the Taliban resistance. However, a drawn out conflict in that country could have the effect of inducing further upward pressure on oil prices. This would obviously not bode well for the sprouting of further "green shoots".

Final Observations
We note that public sentiment concerning the liklihood of a recovery was slightly diminished during the month of May. The optimism spurred by the appearance of the "green shoots" and concomitant equity market rally has been partially displaced by the realization that there is no true catalyst for a sustained recovery. Disaster appears to have been averted, however job losses, foreclosure/delinquency rates, rising fuel costs, and continued bank failures have served as a sobering reminder to the public that we are not "out of the woods" yet. The emergence of frugality as a popular concept should continue to affect consumer spending, which, as we recall, represents some ~70% of the US economy. Our venue of choice for gleaning insight into this trend are the earnings, statements, and behavior of Procter and Gamble(the company that owns every brand of household necessity that you see on the store shelf). At an investor conference last week, the CEO of P&G, A.G. Lafley, made the following statement:

"In every recession there are hosts of compensating consumer behaviors as they manage a more modest budget. We have to expand our portfolios to serve the needs of those consumers. I think a lot of that is going to last"

P&G is one of the fortunate ones-their products are actually Needed by consumers, and they have a broad enough product mix to emphasize "trade down" products in a recessionary environment. Even they are not immune however, as the Company's most recent 10-Q indicates that Q1 earnings were bolstered largely through cost cutting and lower interest expense-a direct result of subdued Treasury yields. While cost cutting is necessary and helpful, it is doubtful whether this strategy can be successful indefinitely.

We expect that Q2 earnings season will bring with it a host of dissapointments, especially if Treasury yields continue to march upwards, and the consumer continues to embrace frugality as a way of life. Sphere: Related Content

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