While the U.S. economy continues to face significant challenges, financial markets in the U.S. and around the world have in recent months made great strides toward stabilization. This is reflected in sharp rebounds by stock markets, narrowing in yield spreads between corporate and U.S. Treasury bonds and declining rates charged on loans made between banks, otherwise known as LIBOR rates. In sum, risk aversion among investors appears to have significantly declined over the past several months.

Risk Aversion Waning

The VIX Index¹, which measures volatility and risk aversion toward U.S. stocks, has declined sharply from 70 in late 2008 to just north of 30 at the time of this publication, and it appears to support a rising general appetite for risk. Further evidence of recent healing by the capital markets comes via an impressive flow of new offerings by corporations wishing to raise fresh capital in the form of corporate bonds, convertible securities and secondary common stock offerings, for example. This, in turn, has contributed to improving corporate fundamentals, as many companies needing to refinance existing debts and/or raise new equity capital to shore up their balance sheets have been able to do so.

In sum, it appears to us that the multiple and massive steps taken by the U.S. government to stabilize credit markets have worked thus far. Together with interest-rate cuts by governments across the globe, an enormous amount of additional liquidity has been injected into global financial markets. Likewise, steps taken to shore up the U.S. financial system and provide more clarity to investors on which institutions are well-capitalized and which require more capital have helped to calm investors' most extreme fears regarding the financial sector in general. It appears, so far at least, that the U.S. banks' "stress tests" have successfully provided investors with the information they needed in order to make informed decisions about whether to make further investments in publicly traded bank stocks.

Dissecting The Rally

It is important to keep the latest powerful U.S. equity market rally in proper perspective. This rebound has driven the S&P 500 Index approximately 32% above its March 9, 2009 low and has been heavily driven by shares of companies that are generally perceived to be of higher risk: those companies that are more cyclical and/or more highly leveraged, whose fortunes are, in general, more closely tied to the overall macro-economic environment. This includes finance sector stocks, consumer discretionary stocks, and industrials, for instance. These are precisely the same stocks that were punished most severely during the climax of the market sell-off earlier this year. As observed by Bank of America/Merrill Lynch economist David Rosenberg, the top 50 most shorted stocks in the S&P 500 as of the start of April 2009 outperformed the S&P 500 by roughly 19% during the month of April.

Here's another way to look at it-over the March-April 2009 two-month period, the S&P Utilities Sector Index and S&P Health Technology Sector Index, which are generally viewed as less cyclical and more defensive sectors, returned 3.2% and 0.3%, respectively. Meanwhile, the more cyclically levered S&P Retail Sector Index and S&P Industrials Sector Index returned 34.8% and 28.5%, respectively, over this same two-month time period.

Challenges Remain

This is not to suggest the rally is not real or legitimate. Rather, it is meant to point out that a few months ago, stocks were priced for an extremely severe economic scenario-perhaps unrealistically severe-and now, on recent strength, are becoming more reasonably valued relative to macro fundamentals. In other words, the recent equity market rally appears to reflect a view by market participants that the severe crisis-level conditions for the financials sector, the markets and the economy have faded. While financial sector and capital markets conditions have improved meaningfully, and stocks have rallied sharply to reflect this improvement, it is important to remember that we are not quite out of the woods yet; the real economy still faces many challenges that will take time to work through.

It should also be noted that a lot of the recent good news regarding positive earnings surprises by U.S. companies has been achieved not by means of improving revenues or sales volumes, but rather, by means of cost cutting. While it is impressive that U.S. corporate management teams have been adept at reigning in their cost structures, it should also be recognized that U.S. companies still have yet to see any meaningful recovery in aggregate demand for their goods and services. Encouragingly, these challenges appear to be amply reflected on the still-attractive valuations offered by many U.S. stocks that we are finding and owning today.

Opportunities Are Present

In summary, we continue to strive to look beyond near-term economic uncertainties and to capitalize on market volatility as an opportunity to identify fundamentally underpriced stocks-stocks whose long-term worth appears to us to be significantly greater than their current share price. We continue to believe the U.S. stock market offers several ripe opportunities for us to do precisely that.

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Posted: 1 June 2009

1VIX is the ticker symbol for the Chicago Board Options Exchange Volatility Index, a popular measure of the implied volatility of S&P 500 index options.