The S&P 500 ended the second quarter up 0.91% in the quarter but down 1.7% for the first half. Second quarter performance varied with the best performing sectors being Utilities, Healthcare, and Financials all to the upside by 8.35%, 3.75%, and 3.65% respectively, while Materials, Industrials, and Consumer Staples led to the downside by 9.97%, 3.79%, and 1.2% respectively. What continues to be noteworthy is the performance of Utilities. Not only were they the best performing sector this quarter, up 8.35%, but they are also up better than 13% so far this year; second only to the Energy sector. Utilities are highly sensitive to interest rates as well as energy prices. Given the fact that interest rates as well as energy prices have been rising steadily this year and over the last 12 months, it is safe to conclude that the market is expecting interest rates and energy prices to reverse course or at least turn neutral.

Looking Ahead:

The third quarter will start with a variety of conflicting market factors that will likely make for an interesting quarter. On the negative side we have tougher quarterly comparisons, higher oil prices, and, to a lesser degree, a higher dollar. On the positive side we have very high short interest on the NYSE and NASDAQ, low yielding US treasury bonds and potential rate cuts in Europe, and the fact that we are coming ever closer to the end of the line of the Fed rate tightening cycle. In our view, the positive factors will outweigh the negatives leading to a net positive advance for the market. We do expect positive returns for the third quarter although we predict that we will drift in and out of neutral territory for the duration of the quarter.

The Fed: Predictable no more

Although it is very hard to decipher when the Fed and Alan Greenspan will stop interest rate hikes, it’s only logical to assume that after 9 rate hikes, we are coming ever closer to a pause in further interest rate increases. The FOMC stated in its statement yesterday that although energy prices increased significantly over the last 12 months, “long-term inflation expectations remain well contained”. That may be true as far as inflation, but it is more than likely that high energy prices will have a role in slowing down economic growth which will probably be reflected in economic data coming out later in the second half of this year. We believe that this will give further impetus to the notion that the end of rate hikes is near giving way to a neutral mode for the Fed. If this scenario plays out in the second half, we believe that we will witness a rally in equities that will take us from -1.7% on the S&P 500 thus far to somewhere in the high single digits. While the Fed’s previous nine rate hikes were very transparent and, uncharacteristically, often too easy to predict; the next few moves will be a lot harder to read to say the least.

Oil Prices:

With oil prices re-testing and breaking their record levels reached in the first quarter of 2005, we continue to believe that we are more likely to see lower oil prices for the remainder of the year (see our Q2 analysis). Furthermore, unlike the first quarter when oil first flirted with the $60 level, the dollar has appreciated by almost 10% against many foreign currencies since then. This implies that the higher prices are being felt by a greater number of countries putting further downward pressure on demand. Lower oil prices will prove to be a net positive for equities.

Further supporting our thesis for positive returns for the third quarter and the remainder of the year is the fact that the risk-return relation between bonds and equities continues to favor equities. With 1 year treasuries yielding around 3.5%, the S&P 500 carries a dividend yield of 1.85% or a difference of 1.65%. This difference however is only 0.70% on an after tax basis given the maximum tax rates of 35% and 15% for interest and dividends. Add to this the fact that short interest on the NYSE and NASDAQ is at or near 12 month highs (As of June 15, Short interest on the NASDAQ and NYSE was 16% and 9% higher than January levels) we believe that this will further be a catalyst for an upward movement for equities.