INSIGHTS

On October 19, 2010

Bull Market on the Rise

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Many before us have liked to refer to the capital markets as great humblers, and for anyone who sat out September’s historic rise they got a taste of that first hand. Specifically, the S&P 500 returned 8.92% in September and is now up 3.89% in October (through October 18th). This is noteworthy for a couple of reasons. First, September has historically (based on the last fifty years) been the worst month for stocks with an average loss of 0.87%. Second, stocks lost considerable ground in August and many prognosticated this would continue into September. Not only did it not continue, but September posted the best monthly return since April 2009 (when this Bull Market was just beginning) and its best monthly return in over fifty years. At this juncture you might ask, what is their point? We actually have a couple.

First, the markets seldom behave the way we would like or the way the experts say they are going to. Second, it is usually the case where if you miss a little (in this case time) you often miss a lot (in this case return). We don’t love the fact that markets behave this way but unfortunately it is usually the case. We would much prefer the equity markets achieve a gain of 12% in a year by tacking on 1% a month vice losing 0.25% for eleven months and then jumping 14.75% in the last month. However, markets tend to track the latter more often then the former. It is this fact that emboldens many investors to try and time the market using various tools like historical precedence. Unfortunately, for someone who decided to skip September, they essentially missed a year’s worth of return. This is why we often discuss that investing decisions should be based on a thorough analysis of factors such as current valuation and expected earning’s growth rates vice, is this month historically good (or bad) for stocks? In addition, we do think it is prudent to study how far and how fast the markets have moved to help us to decide if it is prudent to dial exposure modestly up or down.

Given the S&P 500 had a record-breaking September and is now up 16.53% from its July 2nd low, we think it is probably very likely the equity markets will experience a pullback in the 3 – 7% range (we would expect to see support around 1100 on the S&P 500) over the next couple of weeks. First, as we have discussed before, it is normal for equity markets to pullback at least 3% approximately every 90 days in a healthy Bull Market. In addition, if we are running hot into earnings season we tend to experience a pullback even if earnings are strong. The good news is the early reports look very good with about 83% running ahead of expectations, however, only about 10% of the S&P 500’s 3rd quarter reports are in. If we then throw in the mid-term elections, which are just two weeks away, we have more than enough reasons for this market to experience a normal correction before moving higher into the end of the year and on into 2011.

We aren’t quite ready to discuss our investing themes for 2011; however, we continue to think our 2010 themes of quality dividends, quality balance sheet and quality growth still apply as 2010 winds down. The one we have discussed the most, quality dividends, seems to be catching on as we have recently seen a large uptick in fund flows. However, given the prospect of quantitative easing part two (QE2) we think investors need to also focus on quality growth, especially the areas of commodities (materials) and international stocks. One of the effects of QE2 will most likely be a weaker U.S. dollar which provides a boost to U.S. investors who invest overseas. Add in the projections of higher growth rates, especially in the developing economies, and we think patient investors who look overseas will be well rewarded over the next 12 to 18 months. In addition, as most commodities are U.S. dollar denominated, any U.S. dollar weakness should translate into higher commodity prices and most likely strong earnings for the commodity producers. Over the next 12 months, earnings for the materials companies in the S&P 500 are expected to grow 28% which we believe will end up being too pessimistic as prices firm up. We thus think investors need to have some exposure to commodities and commodity producers.

As stated above we believe there is a high probability the equity markets will experience a mild pullback prior to moving higher into yearend and on into 2011. However, investors who wait for the pullback based on seasonality (as discussed above), technical indicators or fundamentals can often miss out. We continue to encourage investors to patiently increase equity exposure focusing on the themes we have been highlighting throughout the year. In the beginning of the year, we discussed a projected return for the S&P 500 of 10 -15% for 2010 and in the summer we discussed the S&P 500 at 1200 by yearend and 1325 by the end of 2011. We still think these are achievable and realistic levels as this Bull Market appears to be finally exiting the Grind phase that we entered last October.

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the disclosures webpage for additional risk information. For additional commentary or financial resources, please visit www.aamlive.com/blog.