Another powerful week for the stock market illustrates that there is no arguing momentum. It certainly looks like this rally could continue and perhaps for quite a while. In fact, many market analysts see this trend continuing for a few quarters. It seems clear to this observer that as the market advances in the face of terrible economic news that this rally is likely more about a reassessment of the risk of failure than about economic or business strength. There remains an unprecedented amount of cash on the sidelines and you can almost sense the tension as investors contemplate unwinding their uber conservative strategies in order to climb aboard the rally before it ends.

On the earnings front, expectations have been set so low that it is fairly easy for many stocks to beat the market analyst’s expectations. This will continue to be the case as we move forward for the next several months and keep sentiment improving as a result.

Last week was an amazing week for the stock market. As you can see in the tables below all asset classes ended the week sharply higher with small caps winning the race rising 7.97%.  I have been watching the market, looking for a significant pull-back and now wonder if we have already seen it. (Though the S&P 500 declined by 7% over the last four weeks, it managed to erase those losses in just four days last week.) Despite the fact that economic and political news has created a dark backdrop for the markets, investors are plowing money back in almost without fear. Many would suggest that the greater fear is the fear of missing the rally. Dollars are flowing from cash to stocks.

We are currently in the midst of earnings season. Expectations are so low that even disappointing results are greeted with jubilation. “At least they weren’t as bad as they might have been”. Sentiment is still rising out of a cataclysmic end of the world scenario to something more akin to survival. Even influential bank analyst Meredith Whitney, who last year nailed the demise of our large money center banks raised her rating for Goldman Sachs and even warned against shorting large banks. Things aren’t great but they could be worse. Nouriel Roubini, Dr. Doom had more positive comments on the economy, suggesting that perhaps the worst is behind us.

Even though fundamentals don’t support the continuation of this rally, they almost never do. We are bullish in the intermediate term. We recognize that at some point the reality of huge government spending, higher taxes and muted profit expectations for corporations will come home to roost. Until then, we are glad to own stocks.

The numbers:

Sources: Morningstar (simple averages), Yahoo! Finance, CBS Market Watch. Past performance is no guarantee of future results. Indices unmanaged and cannot be invested in directly. 3 & 5 year returns are annualized and assume that dividends are not reinvested.

Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this newsletter (article), will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio.  Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in this newsletter (article) serves as the receipt of, or as a substitute for, personalized investment advice from Hoxton Financial, Inc. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. A copy of our current written disclosure statement discussing our advisory services and fees is available for review upon request.

Friends:

As we look back on a tumultuous first half of the year, we are struck by the degree to which conflicting signals characterize the investment and economic environment. After a horrendous 2008 and a dismal first quarter in 2009, the second quarter saw robust gains – stocks in fact had their best quarter in more than 10 years. Our portfolios, boosted by successful tactical shifts in our portfolio allocations (especially a large weighting to high-yield bonds), and by significant outperformance from our managers, did considerably better than their market benchmarks.

The conflicting signals on the economy include several positives that helped drive the market’s rebound from its March low. The prospect of a meltdown of the financial system appears past; the government has demonstrated it will do whatever is necessary to avoid a disaster of this scale. And though economic activity continues to worsen, it is doing so at a slower rate, which suggests that we are getting closer to an economic bottom. However, the global economy remains in a fragile state as the effects of massive wealth destruction and the unwinding of a huge debt bubble continue to play out. The ultimate result will likely be lower spending by both consumers and businesses in the years ahead, as the economy in effect resets to the level where it might have been without the artificial boost of the credit bubble. While they probably allowed us to avoid a depression, the massive bailout and stimulus spending (along with longer-term demographic factors such as spiraling health care and other entitlement spending) are causing the federal deficit to balloon, which could lead to dollar weakness and inflation down the road.

Other conflicts are at play that will influence how the environment unfolds in the years ahead. One of these is housing, which started the cycle of damage we are now in. There have recently been a few positive signs including stronger demand and historically high levels of affordability. But a wave of new supply from foreclosures over the next two years suggests the market will continue to struggle. (There is more than a trillion dollars in adjustable mortgages that are underwater and that have yet to reset to higher payments, and high unemployment will make things worse.)

Broadly speaking, these conflicts create a very wide range of possible outcomes. Intellectual honesty demands that investors recognize that no amount of analysis will allow them to determine exactly how the coming years will unfold, therefore we direct our analytical effort toward thinking very carefully about what could happen across a range of possible outcomes. This process of scenario analysis gives us important insights about how to position our portfolios.

In all but our most optimistic scenario, we believe returns from stocks and bonds over the next five years will be no more than mediocre. Fortunately, as we invest for our clients we are not limited to just what the broad stock and bond markets give us, and this is a source of optimism for us. Because this is an environment in which many stocks and bonds have traded at prices below what their fundamentals suggest they are worth, our managers have made investment selections that added a lot of value over their market benchmarks. While some of the lowest-hanging fruit may have been taken, pricing disconnects remain that we think could continue to give our managers a tailwind in the years to come.

Looking ahead, although we are not concerned about imminent inflation, we are considering asset classes that could help protect our portfolios in the case of a declining dollar and/or increased inflation. These asset class moves could include emerging-market bonds, Treasury Inflation-Protected Securities (TIPS, which we’ve already employed in some of our more conservative, bond-heavy portfolios to provide greater fixed-income diversification), and possibly commodity futures.

Overall, our portfolios have a modestly conservative bias. We believe that prudence is called for given the current high level of uncertainty in the economy and financial markets, but that good investment opportunities do exist. We will continue to work hard to identify and take advantage of these opportunities.

As always, we appreciate your confidence, and I welcome your questions.

Best regards,

Rob