STOCK MARKET REVIEW

Read the latest Stock Market Review

• Market Review 1st Quarter 2012
• Market Review 4th Quarter 2011
• Market Review 3rd Quarter 2011
• Market Review 2nd Quarter 2011

FIRST QUARTER 2012 REPORT

FOR BROKERAGE ACCOUNTS

The market rally that began in the fourth quarter of 2011 continued through the first quarter of 2012.  The S&P 500 closed the first quarter at 1,408, a 28% increase over its close of 1,099 on October 3rd.  Investor and consumer confidence were bolstered by stronger than expected economic data in the U.S. and less bad news from Europe.  Blue Chip, or more conservative stocks, such as those represented in the Dow Jones Industrial Average posted a healthy return of 8.8%.  This, however, paled in comparison to stocks considered riskier, as the NASDAQ Composite rose 18.7% for the quarter and the average emerging market fund rose 14.0%. Broad based indexes such as the S&P 500 and Wilshire 5000 were both up over 12% for the quarter.  Bonds were relatively flat with the Barclays Aggregate Bond Index up only 0.3% as investors became more confident in the economy and favored stocks in the quarter.

Over the past six months, the market has slowly returned to more “normal” conditions, with lower volatility and lower correlation between asset classes.  Improved investor confidence is clearly supporting better stock performance as unemployment falls and the housing market shows signs of stability.  Given the run that stocks have had recently, there will be many looking for a near-term correction, and there are still a number of potential risks that could dampen enthusiasm for stocks.  Investors will certainly be monitoring developments out of Europe, the potential for military conflict in Iran and economic growth in China.  Stocks still look attractively valued on a historical basis, and we expect the economy to continue its gradual recovery.  Although we would not rule out a pullback in stocks over the summer, our long-term view remains positive. 

THE DOMESTIC LANDSCAPE:

Falling unemployment has been one of the biggest stories during the first quarter, continuing a trend that began last September.  The unemployment rate fell from 9.0% last September to 8.2% by the end of the March quarter.  Over this time period, the U.S. economy added an average of 200,000 jobs per month, a fairly healthy number considering the relatively modest recovery.  This drop in unemployment has been a big driver of an improving consumer confidence index, which peaked at 71.6 in February before falling to 70.2 in March, well ahead of the 45.4 reading last September.  With consumers feeling more confident about the future, they are more likely to spend on discretionary goods and services, which we have seen through improved retail sales and stronger GDP.  

We are cautiously optimistic that the current unemployment rate will hold through the summer, although we expect the pace of job creation to slow.  Employment benefitted through the winter months from unseasonably warm weather.  This means that weather sensitive jobs that would normally be added in the spring, such as construction, were likely pulled forward into January and February.   Federal Reserve Chairman Ben Bernanke also recently stated in a speech to the National Association for Business Economics that “the better jobs numbers seem somewhat out of sync with the overall pace of the economic expansion.”  Bernanke’s hypothesis is that companies cut more workers than necessary during the 2008/2009 recession and now need to correct for understaffing.  For further declines in the unemployment rate, Chairman Bernanke believes that a more rapid pace of economic growth would be required.  Finally, the labor force participation rate, or the percentage of working age people that are either working or looking for a job, was estimated to be 63.8% in March 2012, well below the 66.0% level before the recession.  As job market conditions improve, people that had given up looking for a job may start to seek employment, increasing the unemployment rate.  

Another employment indicator called the Beveridge curve indicates that job openings as a percentage of total jobs are about 2.6%, similar to what it was prior to the recession when unemployment was 5.6%.  Under normal circumstances, higher unemployment would be associated with fewer job openings.  This would suggest that the additional unemployed lack skills required for open positions and that the “natural” unemployment rate may be several percentage points above pre-recession levels.  A large part of the high unemployment can be attributed to the construction industry, which had an unemployment rate of 17.2% in March, compared with a pre-recession level of around 7% according to the Bureau of Labor Statistics.  Today construction employs about 5.5 million people, compared to 7.5 million prior to the recession, and is responsible for about 1.5% of overall unemployment.  It had long been thought that an unemployment rate of about 5% was healthy and would not create any inflationary pressures.  Today that level could be closer to 7% given that it will likely be a long time before the construction industry returns to pre-recession levels, meaning there is less room for improvement in near-term employment.  

THE GLOBAL LANDSCAPE:

Europe was fairly quiet during the quarter as Greece received another bailout in exchange for a negotiated default on its debt and further austerity measures.  The European Central Bank (ECB) continued its stimulus program known as Long Term Refinancing Operation (LTRO), which is similar to the Federal Reserve’s open market operations that add reserves to bank balance sheets.  The LTRO program in Europe did a good job in restoring confidence in the banking system and keeping interest rates low for countries that have had difficulties borrowing.  Although we haven’t heard the last out of Greece, Spain is likely to be at the forefront for the rest of the year.  Spain currently has an unemployment rate of 23%, with unemployment for adults under 25 at 51%.  Much of the problem in Spain stems from the housing bubble, which was far worse than in the U.S.  From 2001 through 2006 Spain created 50% of all new jobs in Europe as the construction industry boomed, building far more houses than necessary.  With estimates for excess housing inventory ranging from 700,000 to 1.5 million for a country with a population of 46 million, housing starts will likely remain low for some time.  Coupled with private debt of 220% of GDP and rising government debt along with the need to balance the budget, economic growth will remain under pressure for the foreseeable future.  

The potential for a military conflict in Iran and its potential impact on oil prices is another risk to the economy.  Although Iran is an important supplier of oil with 4.9% of global production, the bigger concern is the country’s control over the Strait of Hormuz, where 18.0% of the global oil supply passes on its way out of Saudi Arabia, Iraq and the United Arab Emirates.  Should Iran block the flow of oil through the Strait of Hormuz either in anticipation of or retaliation to a military strike on their nuclear facilities, oil prices would spike higher.  OPEC could compensate for a loss of oil shipments from Iran, but does not have enough surplus production capacity to compensate for a larger loss from the blockage of shipments.  The good news is that between the U.S. Strategic Petroleum Reserves and Commercial Oil Stock in the U.S., it is estimated that there are 224 days of oil reserves to further supply U.S. energy needs.   Such a disruption, however, would likely cause a sudden spike in oil prices and a corresponding drag on Gross Domestic Product.  Historically, this sequence of events has been a precursor to an economic recession.  

Debate over the slowing pace of economic growth in China, or a “hard” versus “soft” landing, has also added to market volatility.  With China now the second largest global economy, a slowdown today would have a much bigger effect on global growth than in the past.  In 2010, economic growth in China reached 10.4%, and the government began tightening monetary and fiscal policy in order to reach a sustainable rate of growth and avoid inflation.  These policy moves were successful and the World Bank recently cut its 2012 growth outlook for China from 8.4% to 8.2%.  First quarter growth in China slowed to 8.1% raising concern that the country has been too slow to add money supply and stabilize economic growth.  The feeling among most economists is that Chinese monetary and fiscal policy has been effective in the country, and it would also be able to stimulate growth if necessary, avoiding a hard landing.  

INVESTMENT OUTLOOK

In spite of the risks, the U.S. economy has room to grow. Housing inventory has returned to more normal levels and housing starts have begun to increase.  Additionally, manufacturing and trade inventories are still at historically low levels and capital goods orders are still fairly modest.  The Institute for Supply Management’s (ISM) manufacturing index rose to 53.4 during the first quarter. An index reading above 50 indicates economic expansion.  The Conference Board Leading Economic Index of leading economic indicators accelerated to 0.7% in February, following a 0.2% increase in January and a 0.5% increase in December.  Economists at the Conference Board believe this confirms a more positive outlook for general economic activity in the first half of 2012.  

After the recent strong rally in stocks, however, any new economic data will receive increased scrutiny than earlier in the rally and could lead to increased volatility in stock prices.  When the rally began last fall, expectations were for poor economic data and any positive surprise added to investor confidence.  Today, expectations exist for much better economic data, and any disappointments will likely lead to a sell-off in the market.  

We feel it is important to take a step back and look at the big picture.  The overall economic landscape continues to improve and employment, housing, industrial production and consumer confidence all look significantly better than they did six months ago.  Stock prices, although higher than at the beginning of the year, still look attractively valued on a historical basis.  We therefore do not feel the need to time the market by selling stocks, but continue to rebalance portfolios as clients reach the upper end of their stock allocations.  Our long-term outlook for stocks remains positive, and we continue to look to add to stock allocations as opportunities arise.  

First quarter earnings reports are likely to be quite good given the stronger than expected economic activity and should support stock prices over the next few weeks.  We will use any retreat in stock prices to continue positioning portfolios toward future global economic growth drivers.  One such driver exists in the burgeoning middle class populations in emerging market countries.  By 2015, projections suggest a total of 244 million emerging market consumers with a similar income profile to that of the U.S. middle class.  This represents an 83% increase over 2011 data.  Quality U.S. based companies able to provide desirable and differentiated products to this emerging market middle class segment will surely benefit through increased sales and earnings.  Beyond this economic driver, we also see additional drivers in mobile and cloud-based computing that will continue to shape and change the global technology landscape and enhance work-flow efficiency.  Here too we will continue to add companies to the portfolio as stock valuations allow.  

While opportunities exist, we are also mindful of investment risks and seek protection against potential pitfalls.  One of our biggest concerns is the possibility of rising interest rates and the negative impact on bond investments.  To protect against this risk, we continue to emphasize individual bonds whenever possible and short-term bond funds less sensitive to interest rates when individual bonds are not an option.  Clients can expect to see continued movement towards short-term funds and individual bonds during the next quarter.

COMMUNICATIONS FROM HC FINANCIAL ADVISORS, INC.

We want to meet with you at least once a year to review and update any changes in your goals and objectives, cash requirements or asset allocation targets. If we don’t hear from you, we will be calling to schedule a meeting.  We want you to understand the decisions we are making on your behalf and be comfortable with your asset allocation.  Please call us with any questions or concerns.  

Stephen C. Biggs, CFP®, CFA

April 20, 2012