May 2010

First-Quarter Results Show Continuing Economic Growth

The Economic Environment

The economic rebound continues as we enter 2010. Final, fourth-quarter gross domestic product (GDP) growth was reported at +5.6 percent, accelerating from the prior quarter’s gain of 2.2 percent. This was the best quarter of growth for the U.S. economy since the third quarter of 2003. Changes in inventories proved to be a key contributor to growth once again, as businesses prepare for improving demand. Business investment and exports also were strong, and consumer spending has been much more resilient than most expected.

Employment trends continued to improve during the quarter. Temporary hiring remained in a consistent uptrend and new unemployment claims declined, hitting an 18-month low in March.¹ These two indicators have been reliable predictors of future gains in permanent employment. The unemployment rate has steadied at 9.7 percent in 2010, after peaking in October 2009 at 10.2 percent. It’s important to note job gains come more slowly than job losses over the economic cycle. During the past 50 years, the unemployment rate has risen about 2 percent per year during recessions, but falls at 1 percent per year during recovery.² So although trends are improving, the return to “full employment” will be gradual.

The continued surge in worker productivity (up 6.2 percent in the fourth quarter of 2009) is one factor allowing companies to rehire at a more gradual pace and also plays an important role in keeping inflation low. In an environment of improving productivity, per-unit labor costs decline, thereby reducing cost pressures in the system. Given the huge amount of slack remaining in both the labor market and spare factory capacity, inflation should be contained in the near term.

Clearly, the economy has responded positively to the myriad stimulus measures put in place both here and abroad in the past 18 months. World economies are returning to growth. In the United States, growth expectations for the first quarter of 2010 are in the range of 3 percent to 4 percent.

Challenges remain, however. Our country’s debt burden has increased significantly as our government pulled out all stops to repair an economy in distress. In addition, significant changes to our health care system will increase costs as well. The result is the likelihood of an increased tax burden for businesses and individuals in the future, which could create a drag on economic growth in 2011 and beyond.

The Stock Market

Stocks rose in the first three months of the new year, stretching the streak to four consecutive quarters of gains greater than 5 percent for the benchmark S&P 500 index. In addition, March 9, 2010, represented the one-year anniversary of the bear market bottom. Since then, stocks have risen 70 percent—one of the most spirited rebounds ever. Below are the year-to-date and trailing one-year returns for the major market indexes:

Index	1Q2010	1-year
S&P 500	5.39%	49.77%
S&P Mid-Cap 400	9.09%	64.07%
Russell 2000	8.85%	62.76%
MSCI EAFE	.87%	54.44%
MSCI Emerging Markets	2.41%	81.08%
Sources: Standard & Poor's, Morningstar, Inc.

This market rally survived an important test in late January and early February when stock prices declined 8 percent from peak to trough over worries about Greek debt and slowing Chinese economic growth. To put this decline in context, the market has seen 10 percent “corrections” about once a year, on average, since 1928.³ However, since the market began to climb a year ago, downside movements like this have been virtually nonexistent. Investors weathered this round of “ordinary” volatility and took the market to new highs later in the quarter.

One of the primary factors in the market’s resilience in recent months has been the surge in corporate profits. Nearly 80 percent of companies reported fourth-quarter 2009 earnings above forecasts, and 2010 profits are expected to grow by more than 30 percent for S&P 500 companies. Lean cost structures, resulting from employee layoffs and accommodated by strong productivity gains, have increased profit leverage and created significant bottom-line improvement. As top-line revenue improves along with the overall economy, corporate profits could reach an all-time high in 2010.⁴ This would be an incredible turnaround from one year ago and should prompt increases in business spending and hiring.

International markets also continued to gain in the first quarter, but at a more modest pace than in the United States. The aforementioned concerns related to Greece and China weighed on these markets, as did a strengthening dollar. In our view, well-selected international exposure will continue to benefit investment portfolios. It will expand diversification and offer exposure to the superior growth potential expected in certain international areas in coming years. Whereas the United States represented 26 percent of world GDP in 2009, our share is expected to decline to 18 percent by 2030. In the meantime, the combined “emerging” markets are expected to build their share of world GDP from 32 percent today to more than 50 percent over the same time frame.⁵ Therefore, owning U.S. and foreign companies positioned to benefit from this shift in incremental growth will be important to investment success.

Given the unfolding, dramatic improvement in profits, stock market valuation is reasonable, at just under 16 times 2010 earnings estimates. In our view, this largely explains the buoyancy of stock prices and environment of diminished volatility. First-quarter earnings are likely to be impressive, but year-over-year comparisons will become more difficult each quarter for the remainder of the year. With valuation at a fair level, trends in earnings throughout the remainder of 2010 will likely become the primary driver of future return potential.

The Bond Market

The Federal Reserve raised its discount rate by .25 percent during the quarter, a change interpreted more as a movement toward “normalization” than as a precursor to imminent tightening. However, the likelihood is that we have seen the bottom in interest rates and they will drift higher in coming months. The benchmark 10-year Treasury note ended the quarter at nearly the identical level that it started in 2010, 3.83 percent, but over the last six months the trend is up. This could be a positive sign, if part of the reason rates are rising from extraordinarily low levels is that the economy is improving. However, if rates rise because investors cannot stomach the increased issuance of U.S. government debt, then it’s less encouraging. To date, the evidence would suggest the former, as the bid-to-cover ratios for recent Treasury auctions have been running at just less than 3-to-1. As government borrowing has ballooned, private borrowing has declined, partially explaining the absorption of the Treasury’s new issuance.

Credit spreads (the additional yield of a bond instrument over a comparable maturity Treasury note) continued to shrink in the first quarter. The extreme example of this phenomenon is the high-yield bond category, which at the peak of the crisis offered yields of nearly 20 percentage points more than Treasuries. This spread narrowed to 6.57 percent at year-end 2009 and stood at 6.01 percent at the end of the first quarter. Declining credit spreads signal continued improvement in the economy and credit markets and less aversion to risk. Spreads also narrowed further in the investment-grade corporate bond and emerging market debt sectors, but from more modest levels.⁶

Ten-year municipal bonds currently offer about 85 percent of the Treasury yield.⁷ Although Treasury yields are expected to rise in the year ahead, the negative impact on total return from municipal bonds may be mitigated by several factors, including:

• Potential for higher tax rates, which increases the after-tax benefit of municipal bond income
• Reduced tax-free municipal bond issuance due to the new “Build America Bond” program that subsidizes municipalities who issue taxable debt
• Decreased tax-free supply and healthy demand should support prices
• Generally stronger credit profile of municipalities versus other issuers of debt

Given the current low level of interest rates and normalization of credit spreads, opportunities for bond price appreciation will be limited going forward. Therefore, return expectations become more closely aligned with bond coupon rates in the various market segments. This proved to be the case in the first quarter, as the BarCap Aggregate taxable bond index gained 1.78 percent, and the BarCap municipal bond index gained 1.25 percent for the three-month period.⁸

The Investment Outlook

Some market pundits have called the rise in stocks of the past year the “most hated market rally in history.” After the severe pain inflicted in late 2008 and early 2009, many investors do not believe this rally is real or sustainable, as evidenced by their actions in 2009. Despite stocks posting returns of nearly 30 percent for the full year, and rallying more than 60 percent from March lows, retail investors in the aggregate withdrew $11 billion from U.S. stock funds. Meanwhile, bond funds attracted nearly $300 billion in new inflows.⁹ Although down from peak levels, cash balances remain high despite rates of return less than 1 percent, another sign of investor pessimism. This market has clearly climbed the proverbial “wall of worry.”

Yet economic and corporate profit conditions have improved dramatically in the past year. The rebound in profits and share prices has increased both individual and business confidence, sparking both to re-engage in the economy. The re-employment of idle capacity (factories, workers, etc.) is still ahead of us and tends to add to economic growth with little opportunity cost, so the outlook for profit growth should continue to be strong.

In addition to improving economics, valuations are reasonable. Stock prices remain 23 percent below the levels of October 2007 and 18 percent below December 1999! Yet S&P 500 earnings have grown from $48 in 1999 to an estimated $75 for 2010, an increase of 56 percent during the decade. Using today as the starting point, investors should expect the next 10 years to be much more productive than the past decade.

The path to further progress will not be obstruction-free. The U.S. debt burden, changes to health care, eventual unwinding of stimulus programs and potential for new credit concerns are some of the current issues. In addition, 2010 is likely to bring new challenges unforeseeable today. Although the issues change, these types of concerns can be found in virtually every prior period, to varying degrees. Our belief is that the best means of navigating future uncertainty is to establish and maintain a disciplined investment plan that emphasizes the following:

• Global diversification
• Emphasis on risk management
• Use of liquid investments to adapt to changing environments
• Appropriate balance of risk and return characteristics to meet needs for income as well as capital growth

Given the sizeable run-up in share prices over the past year, periodic episodes of normal downside movement should be expected. The comparisons for the economy, and the companies that comprise it, will get tougher as we work through 2010. Earnings will play a more important role in setting stock prices going forward. Fortunately, trends are improving, which should result in another productive year for investors.

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¹ Source:  ISI Group
² Source:  JP Morgan
³ Source:  Ned Davis Research
⁴ Source:  ISI Group
⁵ Source:  Goldman Sachs & Co.
⁶ Source:  GS Asset Management
⁷ Source:  Bloomberg
⁸ Source:  Morningstar, Inc.
⁹ Source:  Investment Company Institute

The views presented in this Market Commentary are those of the Investment Committee of BKD Wealth Advisors, LLC and do not represent any specific investment returns or promises of performance in the future. The comments in this Market Commentary are not to be construed as investment advice or the recommendation to buy or sell any specific investments. Before making changes to your current portfolio, please contact your advisor.