By Joseph A. Harrison, CFA, Partner

War, recession, a painfully slow economic recovery, corporate scandals, enormous bankruptcies, and the worst bear market in seventy years, all seem a faded memory as the equity markets staged a powerful rally during the second quarter just ended. The swift resolution of the lengthy period of mounting war-related concerns and tensions has been a catalyst for market recovery. But have all issues been so quickly resolved? Clearly, the answer is no. Corporate scandals are largely behind us. The largest bankruptcies have been announced and the few remaining suspects are well known. The painfully slow economic recovery remains just that.

Forward momentum Ample monetary and fiscal stimulus has been applied which should allow the economy to continue moving forward, although this stimulus is partially offset by state and local tax increases, higher natural gas prices; rising health care and insurance costs. Nevertheless, each month provides evidence of forward momentum. Most recently the Institute for Supply Management, the New York and Philadelphia Federal Reserve Banks, and the May Industrial Production Report all suggested the economy continues to grow. The events of the past three years, however, have been serious enough to mute the economy’s response to the abundant stimulus that has been supplied. Corporations have been reluctant to invest in new projects, rebuild inventories, or hire new workers. Until recently, banks would lend money to only the most credit-worthy borrowers. Consumers, buoyed by huge reductions in mortgage payments, have maintained their spending, but have been restrained by the poor employment environment. While not ended, the most pressing geopolitical risks have been mitigated and underlying confidence in our ability to handle a difficult and dangerous enterprise appears to be growing. We continue to face many potential risks around the world, but they appear to be manageable. The improvement in financial markets is a reflection not only of an improved psyche, but also the steady course of the economy. High-risk bonds were the first indication of improvement as the yield spread over U.S. Treasury Bonds, which reached a record nine percentage point spread last fall, has narrowed to a much more normal four-percentage-point spread. This reflects the growing sense that many poor quality companies will survive in this economy. In a similar vein, the powerful rally in the equity market over the past three months was very broad across the market, and included extreme gains among poorer quality equities. In last quarter’s “Perspective” we commented on the importance of a statistic that measures earnings purity. Interestingly, the stocks of companies with a purity rating of zero have done twice as well as the highest quality companies with a 100% rating in the recent market recovery. Again, the riskiest enterprises that were most severely treated in the long bear market benefited most in the short run as fears of an economic collapse subsided.

“ Consumers ... have been restrained by the poor employment environment.”

In summary: the economy continues to grow. We see signs that companies are willing to invest and banks more eager to lend. This suggests an improving business climate. The positive response in the financial markets makes us more confident that a stronger period of growth lies ahead and that strong companies will again provide positive investment returns. In short, we believe the brutal bear market has ended.

If you have questions about this quarter’s economic review, you may contact Joe Harrison at (216) 830-1131 or e-mail: jah@mimllc.com