Schwab Market Perspective: Healthy Pullback…or Market Turn?

by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
and Brad Sorensen, CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research
June 26, 2009

Fed waits….Feds can’t. While the Federal Reserve seems relatively content to let its current measures continue to work through the economy, the Federal government seemingly can’t stop injecting itself into the market mechanism. As unabashed free market supporters, we’re increasingly concerned that the level of government intervention and debt accumulation could short circuit the nascent recovery we’re currently seeing.
Recession likely ending, but risks remain. Steep recessions have typically been followed by sharp recoveries. We believe that scenario is possible this time around as well, but we need to start seeing some signs of actual growth in the economy.
Given enough stimulus, economies respond. Globally, some budding positives are emerging. China has shown signs of better growth as it pumps stimulus into its economy, but Europe continues to lag other regions in its response to the global recession.
Schwab Sector Views. We view the recent pullback in more-cyclical areas of the market as an opportunity and not a change in market direction. Investors hoping to take advantage of such a move should take a look at our sector views for potential tactical adjustments.
Schwab Bond Views. The bond market continues to show signs of stabilizing. We believe the time is right for investors to look to move outside cash and government-backed bonds. In the longer term, Treasury inflation-protected securities (TIPS) appear to be fairly valued and than they were at the end of last year, but still make sense as a hedge for those concerned about future inflation above the current Fed expectations.

Overview
After a rally off of the March lows that can be considered nothing less than exceptional, the stock market has recently shown a bit more uneasiness. The U.S. market has largely traded sideways, with a couple of decent-sized down days mixed in. International markets (especially emerging markets) have also shown signs of some fatigue—again after a very nice run since March. Is this action a signal of a much more serious breakdown to come, or something more benign?

We still remain largely constructive on the U.S. and international markets and view the recent action as a necessary consolidation/correction phase. According to various investor sentiment indicators, it appeared that—while not at extremes—the level of bullishness was getting a bit elevated. We believe that it’s a healthy sign that we’ve been able to work some of that optimism off, while still largely holding on to much of the gain made since March.

In fact, looking at the areas of the market that have been hardest hit bolsters that belief, as many of the beneficiaries of the reflationary trade—such as materials and emerging markets—pulled back the most, alleviating some overbought conditions. For investors who’ve been reluctant to move back in to the market (and judging by the below chart there are still many of you), we renew our call to bring equity allocations back up to normal levels an attempt to escape the miniscule returns being offered on many cash vehicles.

The recent Fed meeting passed without a lot of fanfare, a sign of continued easing financial and economic stresses in the market. Although the Fed has no immediate plans to remove some of the massive stimulus put in place, the Federal Open Market Committee did reiterate some cautious optimism about the economic recovery.

Globally, China has shown signs of accelerating growth, and stock markets in emerging economies have done quite well this year—despite the latest pullback. Massive global stimulus has aided those rallies, but we’re watching to see what happens as the stimulus measures fade and the real economy starts to function on its own.

What does this mean for your portfolio? If you don’t have much exposure to international markets right now, consider easing into them. But be mindful of your personal risk tolerance, and always try to keep your portfolio as diversified as possible.

If you’re interested in a more active approach to investing, we offer tactical investing ideas, which you can find in our equity sector views.

If you’re willing to take on more risk in your fixed-income allocation, we suggest you look to corporate and municipal bonds. Get more ideas from our bond views at the end of this article.

Fed waits….Feds can’t
The Fed showed no signs of either extending their bond purchase program to try to keep down Treasury yields, or to start withdrawing some of the "emergency" stimulus, as economic data continues to show modest improvement. As an expert on the Great Depression, Chairman Ben Bernanke has undoubtedly noted that much of the blame of the crisis has been placed on a Fed that, at the time, tightened monetary policy prematurely—a scenario that he’s sure to try to avoid this time around. Indeed, while inflation may become a concern in the future, for now, a weak money multiplier, high unemployment, excess global capacity and low wage pressures lead us to agree that monetary tightening is not yet necessary to fight potential price increases.

However, we’re a bit concerned over the recent rise in Treasury yields and the corresponding move in mortgage rates. Much of the rise in Treasuries can be attributed to a normalization of the yield curve as investors moved back out the risk spectrum and away from the safety of Treasuries, but the rise in mortgage rates has the potential to stall the tentative housing stabilization we may be seeing. In fact, we’ve seen mortgage applications fall during the past couple of weeks, a somewhat concerning development. Should rates continue to move higher, the Fed may be forced to move more aggressively, or risk losing some of the hard fought ground it’s won.

While the Fed seems content to sit and watch for now, the Federal government shows no such restraint, despite a growing chorus of concern about the level of government involvement and spending. It’s too early to have definitive views on the impact the proposed new regulatory structure may have on the markets in general, and financial companies more specifically, as the Administration’s plan still has to move its way through Congress—where it will undoubtedly undergo numerous changes. However, while there’s little doubt some revamp of the regulatory requirements and structure is needed, we’re concerned about overreach that could stifle innovation and growth. We’ll be watching the progress of these proposals carefully, and the implications to the investing world will become clearer as we move forward.

Our worries about the level of government spending were exacerbated further with the recent proposals revolving around the health care debate. While it’s too early to comment on the specific impacts on various segments of the market, as the plan will undoubtedly evolve during the next several months, the price tag associated with any of the plans catches our attention.

With at least a portion of the recent rise in Treasury yields attributable to debt concerns, and countries around the world increasingly disparaging the dollar as a reserve currency, adding over a trillion dollars to the tab seems untenable to us at this point. Although we don’t believe the dollar loses its reserve status any time soon, we’re in a tenuous time during which the government needs to tread carefully, as continued massive debt issuance could contribute to a “double dip” recession.

On the "cash-for-clunkers" proposal, committing $1 billion (though not a huge amount of money in the grand scheme of things) to a program designed to entice people to get rid of largely paid-for vehicles to buy new cars with borrowed money seems to us to be a road ill-traveled in the past.

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Recession likely ending, but risks remain
Historically, the sharper the decline, the steeper the recovery—and the economic plunge we experienced in the fall of 2008 was without precedent. Inventories have plunged to record lows, indicating that manufacturers will eventually have to accelerate production just to meet current demand.

The Conference Board’s Index of Leading Economic Indicators (LEI) index rose in April and May, and the strengths among the components exceeded the weaknesses in both months. The turnaround in April was the first sign of strength in 18 months, and the best consecutive two-month improvement since November/December 2001 (just after the last recession ended in October 2001). This index is comprised of 10 individual components, and the indicator has had a strong track record in identifying the end of previous recessions.

As such, there’s a chance the recession is already over. However, the combination of the worst financial crisis since the Great Depression and bruised consumers will likely keep a lid on growth in the long term, and could imply the risk of a W-shaped recovery.

Consumers comprise 70% of gross domestic product (GDP), and they remain bruised—they’re embracing frugality, saving more and postponing purchases. Consumers are allocating funds away from expenses and towards funding “emergency funds” in case of job losses and/or cutting debt levels. However, consumers have only just begun the long process of deleveraging.

Mortgage loans constitute more than 70% of consumer household debt, and high levels of debt service illustrates part of the foreclosure problem. Home prices will likely continue to fall due to elevated inventory of existing homes available for sale, and combined with rising unemployment, foreclosures will remain a problem.

However, the unemployment rate is a lagging indicator, while initial jobless claims are a leading indicator. The four-week average of the latter has now fallen by more than 40,000, which has historically indicated the end of prior recessions.

The United States has not experienced the type of consumer deleveraging that likely still lies ahead, and therein lies the risk of a "double-dip" in economic activity. The market rebounded on the potential for the first leg up of the economy, and is now looking for evidence of more concrete sustainability. In short, merely getting worse at a slower rate (or "second derivative" improvement) isn’t going to cut it any more; it appears that actual signs of growth need to emerge to push the market higher.

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Given enough stimulus, economies respond
Stimulus measures enacted around the world have slowed the pace of economic decline in most countries. This has been good news for the S&P 500 Index, with over 40% of revenues being internationally based.

China was the first economy to resume expansion, likely bringing the rest of the world with it. China’s $585 billion fiscal stimulus equates to roughly 18% of its GDP, compared to less than 6% in the United States, and is being implemented quickly. The Chinese government has a strong positive trade balance and current account surplus, which provides flexibility to use aggressive fiscal policies to jumpstart growth—growth to avoid social unrest that could result from over 20 million migrant workers loosing their jobs, according to official estimates.

While consumers represent over 70% of U.S. GDP, consumer spending accounts for only 35% of Chinas, and the savings rate exceeds 30%. In order to be less dependent on exports, the Chinese government has been enacting programs aimed at driving domestic demand.

The range of Chinese stimulus is far-reaching and includes:

Banks, largely state-owned, have lent $850 billion in loans year-to-date through May—higher than was lent in all of 2008.
Export tax rebates continue to grow.
Incentives for auto purchases have driven sales to a level now greater than in the United States.
Vouchers to purchase appliances and consumer electronics.
Reducing the minimum equity requirement to purchase a home from 35% to 20%.

Stocks have responded to the stimulus and improving economy by driving the Hang Seng Index up about 70% from the bottom.

We’re positive on emerging markets due to the combination of healthier financial institutions, cheapened currencies, current account surpluses and faster economic growth. However, emerging-market stocks have been outperforming developed international markets in 2009, and can be highly volatile. Emerging markets as a whole have about double the exposure to commodity markets relative to the S&P 500 Index. Expectations are currently high, and any hiccups in growth or decline in commodity prices could result in market corrections. For emerging-market investors, it’s a good time to review your long-term allocation.

We’re less positive on European markets due to highly leveraged banks, reluctance in providing fiscal stimulus measures and strains on the single-currency system. The European Central Bank reported that eurozone banks borrowed a record 442 billion euros ($622 billion) in their first-ever auction of one-year funds at the ECB’s current key rate of 1%, indicating banks believe ECB interest rates are unlikely to fall further. The ECB is far behind the rest of the world in taking action, and thus far Europe has been lagging the world in recovery.

The dollar and U.S. Treasuries sold off as traders began to worry about massive deficits and resulting U.S. government debt issuance to come. Despite concerns over China’s role as financier of our debt and the resulting impact on the dollar, we believe a crisis in the U.S. dollar is unlikely, as it continues to be the world’s monetary standard for the foreseeable future, as other currency markets lack the liquidity of the dollar. Learn more in Liz Ann’s "Deficits, the Dollar and Exit Strategies."

A modest decline in the dollar is consistent with economic recovery, the “reflation trade,” and is a sign of investors transitioning to a risk-taking environment. As such, we expect investments in international equities and U.S. companies with high exposure to international markets to benefit from a falling dollar.

China is the world’s largest maker of steel and the largest user of coal, according to Bloomberg. The prospect of fiscal stimulus spending in China has driven recent rises in the Baltic Dry Index and commodity prices, but a combination of rising commodity inventories and relief of port congestion in China that drove shipping rates higher may result in prices cooling off from the recent spike, marking time until end-demand reduces stockpile levels.

Despite volatility in individual markets, we believe that Chinese demand will be strong in the second half of 2009 and into 2010, and combined with a declining trend of the U.S. dollar, will support commodities as a group as we move through 2009 and into 2010.

If you invest in international stocks, we suggest you review your holdings and bring your allocation back in line with your long-term target if necessary.

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Schwab Sector Views
We believe the recent pullback in the reflation trade is very temporary in nature, with emerging markets helping to support renewed strength in these areas of the market. Our current sector views reflect this analysis.

We believe that technology, materials and industrials will outperform in the next few months.

Meanwhile, we believe the more defensive consumer staples, telecommunications and utilities sectors will underperform.

For investors needing to increase their allocations to more cyclical areas of the market, we recommend doing so in a controlled, dollar-cost averaging process, as there will be inevitable pullbacks after the nice run many of these groups have already had.

For a deep-dive analysis into our current thinking, read the complete Schwab Sector Views by Brad Sorensen.

Here's a snapshot:

Sectors	Schwab Sector Views	S&P 500 bench- mark weight	Dow Jones Wilshire 5000 bench- mark weight	Date Sector View last changed	Year-to-date return as of
Consumer discretionary
Consumer staples
Energy
Financials
Health care
Industrials
Information technology
Materials
Telecom
Utilities
S&P 500® Index (Large Cap)

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Bond Sector Views
Bond markets seem to be entering a consolidation period, as the steady rise in Treasury yields we’ve seen since the beginning of this year has steadied. Investors have continued to move out of "safer" investments, like Treasuries, but the flow has slowed somewhat as markets stabilize.

Much of the movement, we believe, represents a reversion back toward more "normal" market conditions. Still, the Fed will be grappling with a variety of issues that impact bond investors, including short-term rates, Treasury purchases, and inflation. For now, the Fed indicated in its June 24 announcement that it will keep to the new "status quo," for now.

Fixed income investors should take advantage, we believe, of this market-healing process by continuing to rebalance bond portfolios, taking the opportunity to seek higher returns outside of government-backed bonds or cash. Other non-government sectors, while sharply off their lows of late last year, continue to offer relative value compared to Treasuries.

Investment-grade and high-yield corporate bonds
We think investment-grade corporates are still attractive compared to Treasuries, despite the tightening of spreads as credit markets heal. But diversification is essential. Seek exposure here with a diverse basket of corporate issuers across sectors, or a mutual fund or bond exchange-traded fund (ETF).

Spreads on high-yield corporate bonds have also narrowed dramatically, driving strong appreciation in price. While there may be room for continued gains, volatility is likely and we recommend choosing a well-diversified mutual fund.

Municipal bonds: back to "normal?"
After months of solid appreciation and tightening of yields compared to Treasuries, we believe municipal bonds continue to offer good value for higher income investors in taxable accounts. Even in the face of bad news out of California and other states about budgets and declining tax receipts, bond protections remain strong.

We’d be more cautious about heavy exposure to short-term municipal notes, sold by state and local governments for cash-flow borrowing needs. Yields may be higher for some short-term debt issues ("notes"), but investors should keep in mind that extra yield may come with additional risk as well.

TIPS vs. Treasuries
The relative value of TIPS compared to Treasuries has narrowed since the peak of deflation worries at the end of 2008. Still, TIPS offer protection against inflation if it’s higher than markets expect. Right now, TIPS are priced to anticipate just over 2% annual inflation rate during the next 10 years. If it’s higher, investors holding TIPS should do better than those holding regular Treasury bonds.

Maturity and duration
Given current low interest rates, maturities in the five- to 10-year range appear safer than longer-term bonds. This is especially true if longer-term Treasury rates continue to climb. Intermediate-term maturities offer a good balance of yield and interest-rate risk.

For example, a 10-year Treasury note bought late last year has dropped 11% in value since the peak in prices (and low-point in market rates) in late December; a 30-year Treasury bond has dropped 25%. And despite recent increases, rates remain near record lows.

As always, if you have questions or need help, please contact your Schwab consultant. If you’re not yet a Schwab client but would like to learn more, a Schwab consultant can help. Call 800-435-4000 to get started.

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Important Disclosures

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

The MSCI EAFE® Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the United States and Canada. As of May 2005, the MSCI EAFE Index consisted of the following 21 developed market country indexes: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom.

The MSCI Emerging Markets Index^SM is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. As of May 2005, the MSCI Emerging Markets Index consisted of the following 26 emerging market country indexes: Argentina, Brazil, Chile, China, Colombia, the Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, Turkey and Venezuela.

The S&P 500® index is an index of widely traded stocks.

Indexes are unmanaged, do not incur fees or expenses and cannot be invested in directly.

Past performance is no guarantee of future results.

Investing in sectors may involve a greater degree of risk than investments with broader diversification.

International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.

The information contained herein is obtained from sources believed to be reliable, but its accuracy or completeness is not guaranteed. This report is for informational purposes only and is not a solicitation or a recommendation that any particular investor should purchase or sell any particular security. Schwab does not assess the suitability or the potential value of any particular investment. All expressions of opinions are subject to change without notice.

(0609-9083)

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July Market Snapshot
With Liz Ann Sonders