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Market Commentary - August 8, 2011


Observations on the downgrade – and beyond

The stunning 5.6% drop in the Dow on the first trading day following S&P's announcement of a rating downgrade for the United States might seem to be panic selling, but the decline was surprisingly orderly. Instead, it might without exaggeration be viewed as an almost rational response to disappointing government responses to debt problems on both sides of the Atlantic, the prospect of higher capital costs in the future, and accumulating evidence that the weak economic growth of the first half of this year might be here to stay. Some investors were no doubt worried about an out-and-out recession, but those concerns are, in our view, unwarranted. Recessions typically follow credit crunches, monetary tightening, and the collapse of booming economies – none of which describes recent history. Instead, the economy seems in for an extended period of tepid growth of the like that has followed financial crises throughout history – made worse, perhaps, by the recent decline in the stock market that is unlikely to put consumers or producers in a mood to spend.

Investors are now wondering what to do next. Further declines in the stock market cannot be ruled out and will at least make investors who exited the market happy that they have at least preserved most of their principal. Nonetheless, cash-like instruments and low-yielding bonds are likely not the permanent destinations for much of the money that left the stock market in recent days. That money will, at some point, be attracted back to stocks in search of higher returns. It is too soon to tell what sort of catalyst might bring money back to the stock market, especially if the country is in store for a prolonged period of sub-par growth, as many private forecasters now reluctantly envisage. But it is worth noting that historically the stock market has not fared too badly in periods of slow growth.

Table 1: Between 1947 and 2011:

In quarters in which GDP growth was:The S&P 500 returned an average of:
2.5% or more+11.6%
0%-2.5%+5.2%
negative+2.1%
In recession-1.3%

Companies still manage to find ways to find earnings and revenue even in periods of slow growth, as they did in the first half of this year, when both earnings and revenues for the S&P 500 (based on companies that have reported so far in 2Q) rose more than three times faster than the rate of GDP growth.

In times of slow growth, it is only natural that investors should seek out both safety and yield. It should come as no surprise, then, that high-dividend paying stocks outperform in periods of weak or negative growth. According to S&P and Jeremy Siegel of the Wharton School of the University of Pennsylvania, stocks in the two highest dividend-paying quintiles actually had their highest returns in years of slow and negative growth.

History never repeats itself exactly, but in the last three weeks it has been stocks and sectors that have been viewed as safer that have outperformed. Large caps have outperformed small- and mid-cap stocks in the three weeks ending last Friday, according to Yardeni Research, and the best performing sectors of the S&P 500 have been the defensive sectors – consumer staples, health care, and utilities (which contain many companies paying high dividends). It is these kinds of stocks that are likely to continue to appeal to investors who have little appetite for risk but cannot reconcile themselves to unusually low yields on money market instruments and bonds.

This information is compiled by Cetera Financial Group from source material obtained or provided by US federal and state departmental websites, equity index sponsors Standard & Poor's, Dow Jones, and NASDAQ, credit ratings agencies Standard & Poor's, Moody's Ratings, & Fitch Ratings, domestic and foreign corporate issued newswires and press statements, and from referenced compilations and index readings by Bloomberg Professional. The information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The information has been selected to objectively convey the key drivers and catalysts standing behind current market direction and sentiment.

No independent analysis has been performed and the material should not be construed as investment advice. Investment decisions should not be based on this material since the information contained here is a singular news update, and prudent investment decisions require the analysis of a much broader collection of facts and context. All economic and performance information is historical and not indicative of future results. Investors cannot invest directly in indices. This is not an offer, recommendation or solicitation of an offer to buy or sell any security and investment in any security covered in this material may not be advisable or suitable. Please consult your financial professional for more information.

While diversification may help reduce volatility and risk, it does not guarantee future performance. Additional risks are associated with international investing, such as currency fluctuations, political and economic instability, and differences in accounting standards.

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