Despite late summer recession fears, the equity markets turned in an outstanding third quarter. In fact, except for last year's ferocious rally, this was the S&P 500's best third quarter since 1982 and its best September outright since 1939. It was what we on the trading desk used to call a "moon shot" - a rally with all the explosive force of an Apollo space launch.
The strong rally, fueled by record growth in corporate earnings, was further catalyzed by the almost irrational degree of negative sentiment that has dominated the air waves since last spring. We talked about negative sentiment in last month's newsletter when we tried to shed light on the Hindenburg Omen hokum. Hopefully our readers took our advice and stayed off the pessimists' bandwagon.
Profit growth in recovery
As one would expect, corporate profits usually get hit pretty hard during recessions and rebound nicely during the early stages of recoveries. The current recession/recovery has followed that traditional pattern, but with a much more explosive rebound in profits. To get a sense of what I mean, take a look the following graph showing the year-over-year growth in operating profits at companies in the S&P 500 index since 1989.
Since 1989 we have had three recessions as indicated by the blue shaded areas on the graph. The recession in 1990-1991 coincided with the Savings & Loan crisis and junk bond meltdown. At its nadir, corporate profits as measured in the National Income & Product Accounts (this is same data that goes into the calculation of Gross Domestic Product or GDP) declined by 14 percent year-over-year and actually occurred before the recession officially began. Profit growth eventually reached a peak of 22 percent in the fourth quarter of 1992, one and a half years after the recession ended and then quickly fell back to single digits prompting much talk at that time of a potential "double-dip."
The recession in 2001 was precipitated by the dot-com crash and exacerbated by the 9/11 terrorist attacks. Profits declined each quarter during the four quarters leading into the recession and then rebounded to a peak of 40 percent growth in Q4 2002, a year after the recession ended.
The latest recession started in December 2007 as the subprime mortgage tsunami swamped the economy and lasted until June 2009. In this, the longest recession since the Great Depression, brought the steepest decline in corporate profits in the post-war era (-33% in Q4 2008) and registered more consecutive quarterly declines (9 quarters) than ever before since World War II. Little wonder, then, that corporate profits have also experienced one of the strongest rebounds in the post-war era (+77% in Q4 2009). In fact, if current trends hold, we are on track to experience the strongest average annual growth rate in profits since the mid-1970's.
Where do we go now?
If you are like most people, you are probably now saying to yourself, "Well, this is all fine and good, but where do we go from here?" The honest answer, of course, is: I don't know. The gift of foreknowledge is not something most of us mortals enjoy, so I don't put much stock in prognostication. I prefer to deal in facts and focus on sound portfolio structure. But I will say this: Given that the economy appears to be healing and given that so many investors continue to be very skeptical about stocks, and given that so many other asset classes appear to be over-valued, I think stocks look great.