ROTHSCHILD ASSET MANAGEMENT
Third Quarter 2010 Market Review
After a sharp selloff in August, the S&P 500 rebounded strongly in September, bringing its return for
the third quarter to 11.3%. The Russell 2000 also returned 11.3% for the quarter, while the Russell
Midcap gained 13.3%. For the year to date, the S&P 500 is up just 3.9%, compared to 9.1% for the
Russell 2000 and 11.0% for the Russell Midcap.
Investors have been seesawing between exuberance and despair in reaction to the economic news flow.
In August, fear of a “double dip” for the U.S. economy escalated in response to disappointing reports
on housing and consumer spending. In the following month, better news, particularly on retail sales,
contributed to one of the stock market’s strongest September performances ever.
We continue to think that the economy is on track for a subpar recovery, as consumers deleverage their
balance sheets and boost their savings. If the stock market holds its recent gains, it will have a positive
influence on the economy, boosting consumers’ net worth and strengthening both consumer and
business confidence. The dollar, which has been declining again since June, should also help the
economy by making exports more competitive and imports more expensive. And additional action by
the Federal Reserve is likely, perhaps as early as November. A second round of quantitative easing
would reduce long-term interest rates, providing support to housing and other forms of investment.
Some have expressed concern that additional monetary stimulus may raise inflation expectations, but
we think a “whiff” of inflation would actually do the economy some good by creating an incentive to
buy ahead of expected price hikes.
We are now 15 months into the recovery from the recession that ran from December 2007 through
June 2009. At this point it is normal for growth in corporate profits to slow, as the impetus from
companies moving from loss to profit diminishes. This need not be negative for stocks, unless
investors’ expectations are excessive, which they are not. Analysts’ estimates assume slower earnings
growth, and actual results continue to exceed expectations. The market’s valuation also reflects
modest expectations: the S&P 500 is trading at about 12 times consensus estimates for next year, for
an earnings yield of 8.3%, compared to a yield of only 2.5% from 10-year Treasuries.
The biggest positive factor for stocks is strong cash flow. Cash is continuing to build on company
balance sheets, and the pressure to deploy it is rising. With opportunities for growth relatively limited,
we expect increases in merger activity, dividend payouts, and share repurchases. Companies that can
generate cash and deploy it effectively will be the winners in a sluggish economy, and as growth
becomes more difficult to achieve, investors are more likely to differentiate between corporate winners
and losers. In the months ahead, we expect stock prices to be driven more by trends at individual
companies and less by oscillating macroeconomic views.
T. Radey Johnson, CFA
Chief Executive Officer
Rothschild Asset Management Inc.
October 5, 2010
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