After A Volatile Week US Markets End Mixed

By David B. Armstrong, CFA | Jun 28, 2011 | Weekly Market Commentary

We continue to have a headline-driven market yet seem to be stuck in neutral. Last week investors had plenty to think about. We saw an upwards revision to first quarter GDP to 1.9% from 1.8% as well as a healthy Durable Goods report. The Federal Reserve held its policy meeting last week with no change in interest rates here in the states and a possible short-term solution to the Greek debt situation. Combine the announcement of the International Energy Agency’s decision to release up to 60 million barrels of oil from the strategic reserves in the coming months (with about 50% coming from the US) with no real progress on the US debt ceiling and it’s no wonder we seem to be stalled.

The major US equity markets posted mixed results last week. The Dow Jones Industrial Average (DJIA) lost 0.58% to finish at 11,938; the Standard & Poor’s 500 Index dropped 0.2% to finish at 1268.45; and the NASDAQ Composite Index rose 1.4% to finish at 2652.89. The Russell 2000 Index, which tracks the performance of small capitalization stocks, gained 2.0% to finish at 797.78.

It’s the first official week of summer and once again we find ourselves plagued by doubts and concerns of years past; murmurs of double-dip recession, rising European debt and impending inflation, to name a few. While there are always issues and concerns that factor into our economic predictions (and at the time they appear to be the only thing that matters), I would suggest that a few things in recent history have been overlooked.

Corporate Earnings:  First quarter earnings were very good and early indications suggest that second quarter earnings will also be strong. Earnings season starts again in July and as of now, 2011 earnings of the S&P 500 constituents are on track to post the highest corporate profits in history. In fact, in the last six months both 2011 and 2012 estimated earnings have increased.

Valuation: Due to the strong earnings, stocks are trading at attractive levels if you look at the value of two common ratios: Price to Earnings (P/E) and Earnings Yield (E/P).   The current P/E of the S&P 500 is 12.8, which is a substantial discount compared to the historical average of 14 to 15.  Also consider the S&P 500’s Earnings Yield, which is currently at 7.8%. This number is important when used in conjunction with inflation.  When you take earnings yield and subtract current core inflation (1.5%) from it, you get 6.3%.  This is very attractive when compared to the average of the same calculation over the 50 year period, which is just 2.4%. Generally speaking, when the market is above 2.4% stocks appear to be attractive – below that mark they are considered expensive.

End of Quantitative Easing 2 Means the end of the Bond Rally:  Without the Fed creating a synthetic market for bonds, we should see bonds start to trade on more of a supply/demand basis. If this happens, we will most likely see higher interest rates, lower bond prices and, therefore, investor losses leading to flows out of the bond market. Where will this money go? Investors seeking better returns will turn back to the equity markets and we should see prices rise there.

Participation:  Most investors are still on the sidelines suffering from past losses and have yet to fully engage back into the equity markets. Corporations continue to sit in cash or short-term instruments to the tune of trillions of dollars waiting for the right moment – or at least some clarity into our economic future.

Once again, early summer headlines have struck a chord with many investors causing several recent negative weeks. Just because those issues are making the headlines right now doesn’t mean we shouldn’t be looking for the silver lining. Take into consideration the above and we could be in store for a good summer.

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**Standard Compliance Disclosures
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.  To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.  All performance referenced is historical and is no guarantee of future results.  All indices are unmanaged and cannot be invested into directly.  Stock investing involves risk including loss of principal.  The Dow Jones Industrial Average is comprised of 30 stocks that are major factors in their industries, and widely held by individuals and institutional investors. The Standard & Poor’s 500 Stock Index (S&P 500) is an unmanaged capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The NASDAQ Composite Index measures all domestic and non-U.S. based common stocks listed on The NASDAQ Stock Market. The market value, the last sale price multiplied by total shares outstanding, is calculated throughout the trading day, and is related to the total value of the Index. The Russell 2000 Small Stock Index is an unmanaged index generally representative of the 2000 smallest companies in the Russell 3000 Index.  The Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values.