End Of Quarter Market Thoughts.

Statistics compiled by Bespoke Investment Group and written up in Barrons this past weekend, indicate that the just completed third quarter was the weakest since 1928. I haven't looked that far into the past but I do know that this quarter was the worst 3rd quarter performance since 2002.  If you remember back then we were getting ready to invade Iraq.  The S&P 500 was down a bit more than 14% for the quarter.  It lost 7% in September. For the year the index is down just a bit over 10%.  Our markets ended up being the best house in a bad neighborhood. Overseas markets fared much worse in the quarter. According to Bespoke {linked above}, Russia was down the most at -34.35%, followed by Italy with a -32.54% decline, Germany at -32.06%, and France booked at -31.08% loss.

Taking a look at the chart above shows that most of our damage was actually done mid-summer. {You can double click on the chart to make it larger and easier to see!} Stocks took in most of their losses  between July 26 and August 8th. Markets have traded roughly flat since then, albeit with a sharp increase in volatility.   This reflects investor anxiety and indecision over the economy and the global debt crisis. See our column on market swings for a more in depth discussion on volatility.

The markets sniff recession or at the very least a period of much slower growth than was originally forecast back in the spring. The European debt situation reminds many of the problems we experienced here in 2007-08.  The political stalemate here at home has also done nothing to help investor confidence. One of the catalysts that began this current downturn was S&P's downgrade of U.S. debt.  That came on the heels of our politician's inability to come to a government funding agreement back in mid-summer.  So far economic data does not seem to support recessionary fears.  We will get a better idea of that possibility in the weeks ahead as corporations report 3rd quarter earnings and give us some indication of what they are seeing going forward.  One positive take away is that so very few companies have "pre-announced" earnings shortfalls for the quarter just finished.  That likely means their businesses held up during the summer or any sales declines were within expectations during what for many companies is a seasonally weak period.  It will be the forward guidance they deliver in the weeks ahead that investors will focus most upon.

I am not in the recession camp at this point. I think it is likely we'll skirt an actual decline in GDP although growth may be slow enough in the next few quarters that it feels like we're in one. It is also unclear to me how much stocks are already discounting that scenario given the 20% decline in prices we've seen since the spring. That being said, the market's vote far outweighs my opinions and we'll take our cues from how stocks behave in the coming weeks. In particular we will see whether stocks can hold above the floor put in back in August which has turned into that dark red support line you see highlighted in the chart above.

As we noted previously in a column  "What is it About August?" , we've had the defensive team out on the field most of the time since last spring. This has in general meant for many clients and strategies carrying larger than normal cash positions, redeploying assets and concentrating on sectors and groups that we think are historically cheap and that may act as hedges in a slower growth environment. One area in which we have taken further position's are ETFs that concentrate on dividends. Many of these are at historic levels when measured against bonds and bond funds.  While dividends can always be cut in a recession, we believe that prices currently reflect most of that possibility.  Dividend paying stocks and ETFs should also hold up better in a declining market environment than most other sectors and groups.  We will likely continue to be interested in dividends as long as this historic difference versus bond yields stays around.  

October typically signals the end to the period of seasonal weakness in stocks which we discussed here last summer.  November and December are typically stronger months for the markets. Even in 2008, one of the worst years for equities that I can ever remember, stocks advanced close to 20% from their lows to their close on December 31st. We should also have a much better idea on economic growth after companies report over the next month and that should enable us to begin to build our game plan for 2012.

We have been using a year end price target for the S&P 500 of 1,350 to 1,400 for 2011. That price target is still a possibility if corporate earnings come in on target and investor confidence rebounds. However, given where we are in the year and given the current level of uncertainty both here and abroad, we think those price targets are now less likely to be achieved in 2011. We will instead bring our year end range down to 1,250-1,300 for the S&P 500.  That is still a 10-15% potential increase in asset prices by year end. We will use a preliminary price target of 1,350-1,450 for 2012.  That's a 20-25% potential increase in stock prices over the next 15 months.  I'll warn you now though that these price targets are based on the US and world economies avoiding a major recession next year.  A recession would likely lead to substantial revisions lower in these 2012 estimates.   While a recession does not seem likely based on current economic data, that possibility has risen over the summer.  We place the odds of a recession in 2012 {recession being  defined as two consecutive quarters of decline in GDP} as between 20-25%.  While that is a lower probabilty event, it is not zero.  We will monitor this situation closely in the months ahead.

Finally I will say that you have to go back to my late high school and college years {1977-1983} to find such a sustained period of anxiety in this country.  From the economy to politics we seem to have taken a most pessimistic view regarding nearly everything.  Of course Americans could be forgiven about their sour mood given what's happened over the past decade.  Yet even a cursory view of our history shows that at some point we muster up the will to fix what's broken.  This time could be different, but I'll bet with history and say we'll look back on this period as part of the groundwork that laid the foundation for better times ahead.  Why I think that is a possibility is the stuff of another article at a future date.  Stay tuned!  

*Long ETFs related to the S&P 500 in client and personal accounts.

**Please note that the above reflects solely the opinions of Lumen Capital Management, LLC. As such it is designed solely for the clients and friends of our firm. Since we do not know the investment parameters of casual readers of this blog, they are advised to consult their own investment adviser's or do their own homework. Nothing in this posting should be construed as a recommendation or a guarantee of any sort. Better yet, hire us and we'll show you how our work is done!!!