What may come as the biggest surprise to many investors at the year’s halfway point is that the broad equity market, as defined by the S&P 500 Index, has returned more than 8 percent year-to-date.
With fear-gripping headlines, the re-emergence of daily volatility and some high-profile Supreme Court rulings, investors have had sufficient reason to believe that stocks have been beaten into negative territory, but as is often the case with investing, perception can lie far from reality.
Although historically the end of the second quarter itself has not been a fundamental catalyst point for the equity markets, the past few years have seen the summer months serve as a turning point for stocks.
In 2010, the Standard & Poor’s 500 was down approximately 9 percent by June 30, but rallied to close the year up 11 percent. Conversely, in 2011 stocks had earned gains of just over 5 percent at their summer peak before shedding them all and closing the year unchanged.
Investors are now left to determine if this summer will again usher in second-half changes. Results to the upside would certainly be welcomed, but there are more than a few risks still lingering, and two distinct concerns stand out for the effect they may impose between now and 2013.
The foremost concern must be the perceived fragility of the economy.
While the threat of recession still remains relatively low, there is no denying that economic performance has recently cooled, both domestically and internationally. Data from the federal government suggests that job growth has stagnated, with gains in the private sectors not able to grow fast enough to either counteract cuts in the public sector, or effectively lower the unemployment rate.
Job losses not mounting
Luckily, job losses are not mounting, so the risk of unemployment spiking to double digits again is small. In addition, economic activity in the manufacturing sector, as measured by the Institute for Supply Management index, contracted for the first time since July of 2009.
While this report marks the biggest retreat in almost three years for the ISM, it is not unlike recent slowdowns experienced in the summers of 2010 and 2011 that failed to send the economy into recession.
The markets will use the second-quarter earnings season to measure corporate returns against economic weakness. If corporate earnings show widespread weakness, or if full-year guidance estimates are revised lower, investors may use this information in conjunction with the lackluster economic reports as an excuse to reduce equity positions. This scenario would closely mirror what occurred in 2011.
If earnings surprise to the upside, or if guidance is increased in sectors that are specifically economically sensitive, investors would have reason to largely ignore the soft economic data and increase equity exposure. This pattern would emulate what the equity markets experienced in 2010.
The start of the third quarter also means that the country is just over four months away from Election Day. While the stock market does not generally predict the outcome of an election, it is often said that the markets prefer gridlock — a divided Congress, or at least a divide between congressional and executive power.
The logic suggests that the gridlock would lead to less legislation being passed, which in turn would lower the possibility of increased spending and/or new regulations that could cloud the business environment and the equity markets.
This is another case where perception has separated from reality. Since 1900, the only combination of executive and congressional power that has produced negative annualized returns in the Dow Jones Industrial Average is under a Republican president and a split Congress. In the past 112 years, this has only occurred roughly 10.8 percent of the time, and has accounted for an average annualized loss of 4 percent.
All other combinations of power have resulted in positive annualized returns, including when power is controlled by one party in both the White House and Congress. In fact when Republicans have controlled both branches of government (23.4 percent of the time since 1900) the Dow has averaged an annual return of 7.0 percent. Conversely when Democrats have controlled both branches (35.8 percent since 1900), returns have averaged 7.3 percent.
Investors who focus solely on the risks associated with economic volatility and political uncertainty over the next six months may face disappointment. Numerous other risks, such as the Greek debt default, a Spanish bailout, tensions with Iran and a slowing Chinese economy — some of which still linger — gripped market attention in the first six months of the year, and yet relatively healthy gains were still achieved.
Kevin Fusco is senior vice president of Fusco Financial Associates Inc. of Towson. He can be reached at 410-296-5400, extension 109, or Kevin.Fusco@LPL.com.