june 2013 Economic and Market Commentary

Worldwide Quantitative Easing continued to push stocks into record territory in the month of May despite weak economic and corporate earnings reports. However, within the stock market there are two contradictory trends that developed over the past six weeks of trading which cannot last much longer.

In mid-April investors started speculating the Fed will soon begin to unwind the amount of stimulus being provided to the economy. Since that time those stocks that DO NOT derive as much benefit from the Fed's stimulus program (high-dividend, lower-volatility stocks) have sold off.

Meanwhile those stocks that benefit the most from QE continue to rally higher despite these same concerns over the likely tapering of QE. This might make sense if data such as hiring activity and corporate earnings was rapidly accelerating, indicating the economic recovery is becoming more robust, but this is not the case.

The trading in other asset classes shows the same trends. More conservative investments such as gold, Treasuries, and REITS have all sold off while the most cyclical stocks are rising the fastest. Investors clearly expect economic conditions to improve dramatically in the United States the second half of the year.

The reality is that the global economy has been deteriorating over the past few months, as highlighted by weaker trade activity and lower manufacturing activity in many countries. The U.S. economy is in somewhat better shape, but corporate earnings growth has been declining and earnings forecasts have been steadily revised lower for the rest of the year. GDP grew at only a 2.5% rate in the first quarter of this year, thanks in large part to inventory restocking. Since inventories levels are now adequate, most economists expect growth to slow to about 2% for the second quarter.

However, the consensus estimates for corporate earnings growth in the second half of the year is a very strong 9.6%. We don't think this is realistic, especially given that earnings can grow only through two ways; revenue growth or margin expansion. Revenue growth will remain sluggish in an economy that is only growing GDP at 2%, which might be optimistic given the effects of the Government's sequester spending cuts and higher Social Security taxes have not fully been felt yet. Margins are at historically high levels thanks to corporate downsizing and it seems likely they will fall as hiring picks up.

In addition to the weakening economic data, stock market valuations are stretched after a long run up in prices and most market sentiment gauges we follow are at all-time highs. All of these factors are indicative of a short term market top, and the catalyst for a short-term decline could come when investors realize that growth expectations are too high.

So the likelihood of a market correction is high. At the very least we expect the trends described above to reverse. Stocks that typically do well in the current environment are those that don't possess aggressive growth expectations, generate plenty of cash and have a history of rewarding shareholders through dividends and stock buybacks.

Brian S. Sommers, CFA Director and Portfolio Manager

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