Note To Institutional Clients: Second Quarter 2011

Here's what I am telling the institutional clients I work with:

Despite some pretty formidable economic and political headwinds, stocks managed to hold on to most of the gains achieved during the first quarter of 2011. Year-to-date, the S&P 500 has produced a total return of +6%.

For the second quarter, the total return of the S&P 500 was +0.1%. Higher quality stocks lead the way, lead by health care (+7%) and utilities (+5%). Financials continue to lag the broader market averages, and were the worst performing sector for both the second quarter (-6%) and for the first half of the year (-4%).

It would be easy to turn cautious on the outlook for stocks. After all, recent economic numbers indicate an economy that is slowing. Unemployment remains stubbornly high. House prices in many parts of the country have continued to slide despite historically low mortgage rates. Problems in countries like Greece and Portugal threaten to spread across the euro zone, with negative implications for the entire financial system.

Yet we remain positive on the outlook for stocks, at least for now. Valuation of stocks, for example, continues to be attractive. According to financial publication Bloomberg, the S&P 500 is currently trading at just under 13 times income, the lowest level since 1985 (except for the financial crisis in the fall of 2008).

Low interest rates will also attract investors to stocks, in our opinion. Our bond group is not expecting any significant rise in interest rates for the foreseeable future. In many cases, corporate bond yields are lower than the dividend yields from the same corporate entity. Stocks can offer better income plus potential capital appreciation for longer term investors.

While corporations have reported difficulties in raising prices, most earnings reports continue to show improvement over prior periods. Corporations have streamlined operations through creative use of the internet, and in some cases moved manufacturing offshore to lower cost countries. Corporate profit margins remain at record levels, and with commodity prices dropping sharply during the past few weeks we believe corporate earnings will continue to be satisfactory.

Finally, we should note that widespread pessimism is usually a good time to be buying stocks. Bullish sentiment hit a peak in the spring of this year, and has been steadily declining ever since. The best opportunities in any markets are found when others are too focused on potential risks, rather than opportunities.