| Lummer's Logic |
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| Second Quarter Commentary - Summertime Blues
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By Scott Lummer
Chief Investment Officer, mPower |
July 3, 2001
The stock market showed signs of recovery during the second
quarter, although overall results are still down for the year. The S&P 500, a broad
measure of the market, gained 6 percent but is down 7 percent for the year. The segments
of the market that did the worst in the months leading up to April 2001 performed the best
during the second quarter (April 1-June 30). The technology-heavy NASDAQ rose by 18
percent, but is down 12 percent for the year, while large-company growth stocks increased
by 8 percent, but are down 11 percent for the year. Conversely, large-company value stocks
rose only 4 percent during the past three months yet are only down 2 percent for the year.
Despite the solid returns produced by stocks during the
second quarter, many investors are disappointed. One reason is that despite the gains, the
market has lost ground over the past 12 months. For example, the S&P 500 lost 16
percent over the last year. Another reason is that the market was much higher in mid-May
than it is now — over the past six weeks the S&P 500 has fallen by 7 percent.
What Happened?
At the beginning of the quarter, there was much concern
about a potential recession, and the focus was on any economic data that shed light on the
likelihood that such a recession might occur. In my April commentary, I said that I
believed the worst was over, although we would see much daily volatility because of the
focus on economic news. Although there were mixed signals, the economic news has improved,
and the stock market has reacted accordingly.
The Next Quarter
I am cautiously optimistic about the next three months.
Most of the economic data is promising. Consumer confidence has been slowly rising.
Unemployment is still at a relatively low rate of 4.5 percent (to give you some
perspective, from 1974 to 1996 unemployment was never lower than 5 percent). And the index
of leading economic indicators has been gaining.
The main concern is the economy's relatively low growth
rate, currently at 1.2 percent. However, the Federal Reserve has cut interest rates six
times during 2001, and the impact of those cuts is just beginning to be felt. There is
also legitimate concern about the inflation rate of 3.5 percent, which has been heavily
influenced by the rapid increase in energy prices. The interest rate cuts may cause
inflation to increase.
As for the stock market, I think we will likely see
continued slow growth with a high degree of volatility. The stock market growth will
mirror economic growth. However, there are two significant risks — one for the broad
market and a larger risk for the technology sector of the market.
Regarding the broad market, since the economy is still
relatively fragile, any significant negative economic news could cause a quick 5-10
percent drop in the major market indexes. What's more, I don't foresee any more interest
rate cuts — the potential for higher inflation will cause the Fed to proceed
cautiously.
With respect to the sector risk, the potential volatility
of technology stocks is particularly worrisome. Tech stocks are always unpredictable, as
evidenced by the NASDAQ's decline of over 60 percent last year. However, the reason for my
specific concern is that their rise over the past three months has not been justified by
the stocks' fundamentals. We have not seen increases in company profits for most of the
industry, and many of the larger technology companies are still making budget cutbacks. I
don't see reason for panic, but increases in value by one-fifth do not seem warranted. Of
course, there is always the potential for huge gains in this sector, but investors should
be conscious of the downside.
What to Do?
In light of what I just wrote, this certainly isn't the
time to be loading up on technology stocks. I think having a broadly diversified portfolio
that includes some tech stocks is prudent. And, as is always the case, it makes
sense to be heavily invested in equities for the long-term. All of the movements we have
seen over the past year will be long forgotten by the time most of you begin your
retirement.
Although I have seen no hard data to support this, my
anecdotal evidence suggests that most investors are a little less focused on the daily
movements of their portfolios than they used to be. News articles about the stock market
have been pushed off of the front page and into the business section, and I have received
fewer panicky e-mails. I think this is a good thing. Being overly focused on the stock
market can lead to destructive behavior, such as attempting to time the market. Indeed
there are investors who owned equity funds in March 2000, moved out of them a year later
when the market was at its low point, and bought back in when the market was at its high.
The problem with reading a lot of information is that you
start to think you should act on it. But the key to successful investing is not to
overreact to short-term events.
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