Other Updates

The Economic Environment

Economic trends continue to move in a positive direction. This is evident in several data points released in the first quarter, including the following:

• March payrolls increased by 216,000, and the unem­ployment rate dropped to 8.8 percent.  Private sector hiring continued to increase, while state and local municipalities cut more jobs, but at a slower pace.
• The Institute for Supply Management (ISM) survey of the U.S. manufacturing sec­tor moved to its strongest level since 1983, and the ISM service sector reading reached its high­est level since 2004, according to Fidelity Capital Markets.
• The Conference Board’s consumer confidence index climbed to a post-recession high.

The economic data suggest a growth pace in the first quarter of about 3 percent, roughly in line with recent quarters.

Despite growth for seven consecutive quarters, the Federal Reserve has given no indication it is ready to begin raising the Fed funds rate from the current level near zero percent. However, it does appear the quantitative easing program (QE2) will end in June as originally scheduled. In recent commen­tary, the Fed says “the economy is on firmer footing and overall conditions in the labor market appear to be improving gradually.” Yet the Fed is hesitant to begin tightening due to the relatively high unemployment rate and the view that inflation is subdued. The consensus opinion is the Fed will remain on hold until 2012.

Regarding inflation, the core measures remain fairly low, despite the increase in food and energy prices (considered volatile, noncore categories). However, should these noncore prices remain elevated or increase further, they will likely begin to affect overall inflation rates. Slack in the economy, i.e., high current unem­ployment, spare factory capacity, etc., tends to keep inflation at bay. However, continued weak­ness in the dollar will reduce purchasing power, pushing up prices of imported goods. In the near term, the net of these competing forces has been modest overall inflation. However, this could change quickly and will be important to monitor as expansion progresses.

The Stock Market

Stocks posted their strongest first-quarter returns in more than a decade, extending the trend established during the final four months of 2010. Below are results for major world stock market indices:

Stocks faced challenges during the quarter, resulting in a brief period of consolidation from mid-February to mid-March. Unrest in Northern Africa and the Middle East initially affected emerging markets and eventually spread to other world exchanges. The Japan earthquake cre­ated new concerns for investors, in addition to the incredible human toll. Stocks withstood these worries to close the quarter just below the highs of the year.

Given that sources of investor concern largely emanated from foreign lands, U.S. stock market returns compared well to international markets in the first quarter. Within the international realm, emerging markets stocks produced only half the returns of developed countries, as investors chose to reduce risk. However, as conditions stabilized late in the quarter, emerging markets stocks dis­played their fundamental strength, gaining nearly 6 percent in March versus flat returns in the U.S. and slightly negative returns for developed interna­tional markets. We continue to believe the emerging economies remain the most important long-term growth driver in the world, despite underperformance so far in 2011.

Interestingly, all 10 economic sectors represented in the S&P 500 posted gains in the first three months of the year. However, only two sectors—energy (+16.3 percent) and industrials (+8.2 percent)—posted returns above the overall index return of 5.92 percent. Clearly, the robust first-quarter index returns were driven by these two sectors, particularly energy stocks, where results were positively influenced by rising oil prices. The weak dollar also factored into the performance of these two segments, according to Standard & Poor’s.

Valuation remains attractive, both in the U.S. and abroad. Price-to-earnings (P/E) multiples less than 15 are typical in most markets, making stocks attrac­tive given improving economic fundamentals and the current low level of interest rates. Consider­ing the expected gain in corporate profits in 2011, stocks are capable of producing solid returns this year without an expansion in the current P/E multiple.

The Bond Market

The bond environment was fairly benign in the first quarter. Interest rates rose, but only slightly, with the benchmark 10-year Treasury yield moving from 3.3 percent to 3.45 percent during this period, according to Thomson Reuters.

The tax-free bond market normalized somewhat, with concerns about the general health of municipalities receding. The BarCap Municipal index posted a positive return of 0.53 percent during the period. The change in property tax revenue lags the change in home values, so some municipalities are still seeing a negative revenue trend, despite an improv­ing national economy. On the other hand, sales tax revenue has generally been increasing, providing a positive offset.

Most segments of the taxable bond market also returned less than 1 percent during the quarter, according to Morningstar, Inc. Credit spreads—the yield advantage of a certain bond or sector over comparable maturity Treasury notes—were fairly stable, while the slight increase in interest rates had a modest negative impact on bond prices. The net result was a return of just 0.42 percent for the BarCap Aggregate bond index.

The Investment Outlook

The tragic earthquake and tsunami in Japan was a humbling reminder that nature can deliver sudden and unexpected devas­tation. The magnitude and after-effects of this natural disas­ter are among the worst ever experienced, and the human toll is enormous.

Stocks accomplished a milestone during the first quarter, reaching a 100 percent rebound from March 2009 lows. However, sometimes math can be unkind. After a 57 percent decline from October 2007 to March 2009, the 100 percent gain still leaves stocks 14 percent below their 2007 highs! But the pro­gress has been significant, allowing diversified investors to recoup most, if not all, of value lost during the severe market downturn.

In our view, the most important feature of the stock rebound is that earnings have grown alongside share prices; S&P 500 companies are expected to reach record levels of profitability in 2011, according to Thomson Reuters. Stocks still represent good value, even after the recent incredible run. This helps explain the persistently strong market results, despite the multitude of worries that have risen since the rally began.

We expect earnings to report well again for the first quarter of 2011. However, the ability to surprise to the upside will become more challenging as we move forward, given increased expectations and tougher year-over-year comparisons.

Our Investment Committee continues to analyze opportunities to improve the risk and reward characteristics of investment portfolios as we progress through this market cycle. This analysis has led to a recent decision to slightly reduce core stocks in favor of alternative investments. We look forward to opportunity in the remainder of 2011, but also are mindful of risks that linger after a significant economic downturn.

The views presented in this Market Commentary are those of the Investment Committee of BKD Wealth Advisors, LLC and do not represent any specific investment returns or promises of performance in the future. The comments in this Market Commentary are not to be construed as investment advice or the recommendation to buy or sell any specific investments. Before making changes to your current portfolio, please contact your advisor for a personal consultation.