By Bill Stone of PNC Wealth Management

It is an intensely hot day, all things on land and sea being merely variations and shapes of flame, wonderful to look upon but not wholly good to be amongst. -- William Vaughn Moody, American poet and playwright

As the summer weather here on the East Coast has heated up, the global stock markets have continued to melt under the bright sun. As much as investors enjoyed the S&P 500's first-quarter gain of 5.39%, all that and more fell to the wayside as the index slumped, down 11.43% in the second quarter. This has left investors wondering if the market has another 2008-style rout in store.

Market Focus and Our Economic View

In our view the primary cause of continued market weakness is concern that various issues, including European sovereign debt, a China slowdown, and a recent soft patch in U.S. economic data, will cause another global economic downturn so soon after the last. In other words, fear of a double-dip recession.

As we noted, the recent spate of U.S. economic data reporting below market expectations seems to have added to the nervousness. For example, last Friday when June employment data were released, headline job losses of 125,000 broke a streak of five straight gains. A bit of nuance is helpful here, because the recent job numbers were aided by census hiring, which is now reversing.

When one looks at private hiring, the six-month streak continues with 83,000 new jobs in June. Private hiring was less than most would have preferred and average weekly hours also declined, but this indicates to us a soft patch more symptomatic of an economy still transitioning out of the Great Recession than an impending double-dip recession.

It is worth noting that when one uses the National Bureau of Economic Research recession dating double-dip recessions are historically pretty rare. If we define a double-dip as a recession within 12 months or less of another, then there would have been only three in the United States since 1854 -- January 1910 to January 1912 and January 1913 to December 1914; August 1918 to March 1919 and January 1920 to July 1921; January 1980 to July 1980 and July 1981 to November 1982.

Our forecast remains that there will be no double-dip in the United States but that the economic data are consistent with our long-held view regarding a half-speed economic recovery.

Market Drivers

This holiday-shortened week the U.S. economic calendar is very light. With this mind, here are a few factors that could provide a positive catalyst:
  • oversold stocks;
  • bearish market sentiment;
  • second-quarter earnings;
  • European bank stress tests; and
  • valuations.
  • One could pick from any number of indicators to point to an oversold condition in stocks. For example, the percentage of stocks closing above their 200-day moving average was 27%. This is the lowest number since the market recovery began in Spring 2009. While oversold stocks can certainly remain oversold, it does reflect the increase in opportunities for bounces on even the absence of bad news. This might explain the early positive market action on Tuesday.

    This is probably a close cousin to the oversold condition, but market sentiment has turned decidedly bearish. As measured by the American Association of Individual Investors, there are now almost 20 percentage points more bears (42%) than bulls (25%). This is certainly a positive since a higher bearish percentage is a contrary indicator and correlated with higher expected future market returns.

    Second-quarter earnings season begins for the S&P 500 companies next week. Consensus estimates call for year-over-year earnings growth of a little more than 27% for both the headline number and excluding Financials. Though the combination of earnings estimates being raised in the wake of a great first quarter, a stronger dollar, and a softer economic environment in the second quarter will likely keep the surprises from being as good as they were in the first quarter, we forecast a high likelihood that actual earnings will again outpace estimates.

    While much attention will be paid to company outlooks rather than earnings from the past, we enter this earnings season on the heels of a poor market environment rather than following explosive upward moves like the last two seasons. Some good earnings news in a market with low expectations could provide a needed boost.

    With a good portion of worries regarding the global economic situation due to worries about the eurozone banking system, many market participants are eagerly awaiting the results of the eurozone bank stress tests. While there are many questions surrounding these tests, the U.S. stress test experiment provides a successful blueprint. The result should be reported in July perhaps as early as the middle of the month.

    Though valuation is a poor timing tool, it is the best long-term predictor of future returns in our opinion. The S&P 500 now sells for roughly 12.5 times 2010 estimated earnings and has a dividend yield of about 2.1%.

    According to BCA Research, the S&P 500 also sells at the lowest 12- month forward earnings multiple (around 11 times) since 1994 aside from the 2008 plunge. These valuations also compare favorably with 10-year Treasury bonds yielding 2.94% (34 times interest payments) and Baa corporate bonds yielding 6.04% (16.6 times interest payments).

    S&P 500 Fair Value and Downside Risk

    Our December 2009 Investment Outlook discussed our view on a fair value range for the S&P 500 of 1175 to 1275. This range was based on a multiple of normalized earnings of 16.5 to 18 times. Recall that investors should value companies at the discounted value of their future earnings and this method uses long-term average earnings adjusted for inflation to approximate future earnings power. Normalized earnings are our method to cut through the economic cycle noise, in that one should neither pay too much for peak earnings nor too little for trough earnings.

    As a means of trying to stress test our views, we looked at S&P 500 earnings assuming the possibility of a double-dip. If one uses third-quarter 2008 and second-quarter 2009 as a proxy for the recessionary earnings power (both quarters had earnings of roughly $15), annualized earnings would be roughly $60.

    Using 15-16 times earnings, lower than the long-term average multiple, would point to downside risk of 900-960. Unfortunately in a fit of panic such as the one we saw in early 2009 all rational thought exits the market in the short run, but in due course the market actually tends to put a relatively high multiple on trough earnings (23 times in 2002, 19 times in 1991, 16 times in 1970, 15 times in 1958).

    Our fair value target remains unchanged because it was calculated based on a sustainable but half-speed economic recovery and using normalized earnings, which remain below the current estimates for 2010 earnings.

    PNC Investment Strategy Recommendation

    PNC expects the global and U.S. economic recovery to continue, despite the occasional concerns to the contrary. Our expectation of a half-speed economic recovery in the United States is borne out by the recent data. Downside risks certainly remain to our forecast and we continue to monitor the situation closely.

    If, as we expect, there is no double-dip recession, stocks provide value and an attractive risk versus reward for investors with a sufficient investment holding period and ability to withstand the market volatility. We believe the relative performance of stocks to bonds and cash should remain attractive when viewed over a reasonable investment period.

    PNC currently recommends a baseline allocation in our asset allocations in terms of stocks versus bonds and cash, but we recommend a tactical allocation to leveraged loans within the bond allocation in order to reduce interest-rate risk within portfolios. This allocation is an expression of our baseline view that the recovery should continue, which will likely necessitate higher interest rates at the very least.

    Our current recommended allocation attempts to balance the relative attractiveness of stocks and other risk assets, given the improvement we expect in the global economy, with the downside risks to our forecast.

    Volatility may remain for some time as the market struggles to get clarity on the sustainability of the global economic recovery and investors should focus on an allocation to balance that risk with the need for growing purchasing power over time.
    Bill Stone is the Chief Investment Strategist for PNC Wealth Management and PNC Institutional Investments with over $100 billion in assets under management. He is a member of PNC's Investment Policy Committee and is responsible for defining the asset allocations and portfolio strategies used throughout the organization to advise individual and institutional investors. Stone is a cum laude and honor's program graduate of the University of Dayton with a bachelor's degree in finance. He earned a master's of business administration from the Katz Graduate School of Business at the University of Pittsburgh. In addition, he holds the Chartered Financial Analyst? designation and is a Chartered Market Technician. Stone has been quoted in many publications including The Wall Street Journal, Financial Times, Barron's, Fortune, Forbes and USA Today. He is regularly interviewed by Associated Press and Reuters. He is also regularly interviewed on CNBC and Fox Business for his market insights.

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