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Monthly Market Monitor - July 2009

Market Indices1June ChangeYear-to-Date (6/30/09)
S&P 5000.0%1.8%
MSCI EAFE-0.8%5.6%
Dow Jones Industrial Average-0.6%-3.8%
Russell 20001.3%1.8%

Too Far, Too Fast or a Pause That Refreshes?

With the major indexes gaining 35-40+% off their early March lows, the stock market appeared to catch its breath in June. Most analysts attribute the second quarter rebound to confidence that, thanks to government stimulus and Federal Reserve rescue programs, catastrophe was averted. Many economists now believe the economy could finally show growth by the fourth quarter. Signs of recovering consumer sentiment were also showing up, but late in the month many started to worry that the market had gotten too far ahead of solid economic evidence. Those hard numbers will be key to whether the rally continues or a market pull back, possibly to the old lows, is in the cards. Many analysts take heart in evidence of stability developing in the housing and auto sales data. Others believe this may be just a reaction to temporary cheap pricing to clear out inventory and is not sustainable with continually rising unemployment. The next important indicator will be second quarter earnings being released over the next month. Even without a clear improvement in consumer spending, the market could get a lift if, as some suspect, signs that corporate profits may experience a stronger-than-expected snapback in the second half of the year. Gains in business productivity and timely cost cutting in this downturn could lead to a faster rebound in profits, even with a generally slower forecasted recovery.

Profits are a major determinant of longer-term market direction. Another factor, interest rates, is not so encouraging. Longer-term interest rates spiked to almost 4.0% on 10-year US Treasury bonds in June from 3% in March based on sudden concerns over inflation. The biggest negative impact was seen on the emerging housing market recovery as the higher rates translated quickly into a spike in mortgage rates, threatening to end a mini-boom in mortgage refinancings. Most economists believe any sustainable economic recovery is still tied to the stabilization of the housing market and Fed programs to keep people in their homes and dry up the inventory of vacant homes are dependent on keeping mortgage rates low. While rates have receded somewhat in recent days, the growing argument over the potential level of inflation arising from the government stimulus programs will likely remain an important determinant for stock market performance in the coming months.

Conflicting Views of Inflation and Higher Interest Rate Risk

The discussion over inflation boils down to two distinct arguments. The traditional definition of inflation is “too much money chasing too few goods”. This means that cheap money and easy borrowing terms create higher prices as consumers bid up prices on any variety of goods that are in limited supply. The eventual cure is to raise interest rates, making borrowing less attractive. This usually happens at full employment and in an overheated economy. By this definition, most economists would conclude that inflation has little chance for at least the next year, given the excess production capacity in the economy. The unemployment rate is high and expected to rise to over 10% in the next year. Factory utilization is running far below capacity. Moreover, instead of chasing new purchases, consumers are saving and paying down debt. Businesses, except for perhaps gas stations, are having a hard time raising prices. Banks are being careful to lend out the bailout money they received from the government and continue to cut customer credit card limits. Many economists worry that under this scenario the threat of deflation continues to be a bigger concern than inflation.

Other economic experts worry that the basic fundamentals of demand/supply inflation will be overcome by the unprecedented, and what they see as unrelenting borrowing and spending that the government continues to pursue to revive the economy. Interest rates will naturally rise to persuade lenders to continue buying. Compounding the problem is that a large amount of the government debt is being bought by overseas investors, particularly China. At some point foreign borrowers may have other uses for their money and cut back on their purchases, forcing the Treasury to offer even higher rates to attract buyers. This would have the same negative economic and market effects as raising rates to combat traditional inflation. A well-debated future problem for the Fed and the market is if, how, and when they will begin to pull out this immense amount of new money created by the stimulus efforts. The Fed has made it clear they are very aware of the inflation issue and will act to counteract it. Unfortunately, tools used to fight inflation can slow economic growth and many worry that investor’s exaggerated fears of inflation could force the Fed to move too quickly during this still shaky recovery period.

  1. Wall Street Journal, 5/30/09

Prepared by:Martin Cosgrove, CFA
Director of Investment Research
Research Department, ING Advisors Network

The views are those of Martin Cosgrove CFA, Director of Investment Research, Research Department/ING Advisors Network, and should not be construed as investment advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy.

All economic and performance information is historical and not indicative of future results. The market indices discussed are unmanaged. Investors cannot directly invest in unmanaged indices. Please consult your financial advisor for more information.

Additional risks are associated with international investing, such as currency fluctuations, political and economic instability, and differences in accounting standards.

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