Thursday, October 14, 2010

Institutional Client Third Quarter 2010 Letter


Usually at the end of each quarter I write a couple of client letters: one for my individual clients, and the other for my institutional investors. This is what I sent my institutional clients this quarter:

Although September is typically one of the weakest for stock market performance, this year was different: The S&P 500 produced a total return of almost +9% last month. September’s strong showing pulled year-to-date stock returns back into the green, with the 9 month return of the S&P now at +2.3%.

Several things have been striking about the positive performance of stocks recently.

First, while the stock market has moved sharply higher, much of the recent economic data tells a story of an economy struggling to regain some the momentum started in the spring.

Unemployment rates in particular continue to run at very high levels, contributing to the general malaise that seems to have settled throughout much of the country. While stock market performance and economic reality have often diverged in the past, the most recent dichotomy seems particularly noteworthy.

A second striking characteristic of the recent market rally is the high correlation of stock price movements across both industries and sectors. Normally there are areas of strong leadership, while others will lag.

However, in the most recent market action, the market leaders have been the highest beta names (when the market is rising) or the lowest beta stocks (when the market is falling), regardless of sector. This type of market action makes it difficult for stock pickers to practice their craft with any real degree of success.

There has also been a noticeable lack of trading volume in recent market activity. Part of this may stem from the lack of any discernable differences in market action, but it could also reflect a general cautious attitude among the investment community.

Moreover, much of the stock market activity seems to be centered in a relatively small handful of stocks. For example, in the month of August nearly 10% of the trading volume in the stock market was centered on one exchange-traded fund (ETF) that represents the S&P 500. Moreover, 90% of the volume that month was centered on just 112 of the more than 10,500 listed shares.

What seems to be happening, in our opinion, is that much of the rise in stock prices (as well as commodities and bonds, for that matter) reflects a combination of the massive liquidity that the Federal Reserve continues to add to the capital markets as well as the historically low level of interest rates that currently prevails.

While there is no denying that much of the earnings news from Corporate America has been reasonably positive, it seems more plausible that stocks are rising mostly because the other investment alternatives (especially bonds) seems to offer only modest longer-term return potential.

With all of this as a backdrop – mixed economic fundamentals but strong Fed-provided liquidity tailwinds – we start the fourth quarter modestly optimistic for stocks. Stocks continue to offer the best alternative for investors with a longer term time horizon, particularly in those areas which offer an attractive combination of reasonable valuations and often attractive dividend yields. In short, as the old adage goes: “Don’t Fight the Fed”.