Recovering! Two steps forward (April and May); one step backward (June). In the March President’s Message to our clients, we predicted that the stock market was close to resolving a vicious bear market; it appears that we were right. The Dow made an important low on March 22, then tested it on April 4. The NASDAQ also made a low on April 4, and it appears this date was the market bottom for this cycle.

Stocks rebounded very well during April and May. June started off well, but then fell apart. This is because a record number of companies announced that their results were likely to be lower than general expectations. (The thirty-day period before the close of a quarter has now developed into a pre-announcement season. Under the new disclosure regulations, companies that are likely to produce results significantly different from general expectations are expected to disseminate that news to the public.)

Although the equity markets may have bottomed in April, the economy clearly has not. Remember that the overall economy typically takes six to twelve months to respond to efforts to stimulate it, but that the equity markets usually anticipate economic changes by three to six months. So between anticipating and seeing economic evidence, it is not unusual for participants to have an ongoing debate about the timing of a recovery or even its premise. This underlies a great deal of the volatility that we are experiencing.

Volatility is certainly alive and well. The setbacks are quick and brutal, the recovery sometimes the same. Market emphasis jumps from sector to sector, from growth to defensive, from small to large and back again. This is frustrating to be sure, but is normal action during early stages of market recovery.

During difficult periods, it is natural for investors to focus on risk. Every announcement, hint of trouble, rumor, and concern is endlessly analyzed. The fact is that those price declines that have already occurred account for most of these events. After a major decline, precise measures of depressed revenues and earnings do not yield much value. The outlook for the future cycle is what is truly relevant. (Since our outlook is optimistic and we like to buy low, we think this is a great time.)

The bond market has entered into a more difficult period, with the debate about economic recovery affecting prices. During periods of economic optimism, yields increase and prices decline. During pessimistic periods the opposite takes place. In general the yield curve has become steeper. Short-term rates are coming down in response to Fed policy and longer-term rates are moving up, anticipating a stronger economy.

Treasury and municipal issues have been the most volatile. Longer-term corporate bonds have been buoyed by the expectations for a better economy, bringing more confidence in credit ratings.

We probably are in the trough for economic performance right now. Whether or not the second quarter skirted negative growth is a close call. The third quarter should be better. Some impact from the first interest rate cuts may begin to appear and the first checks of the federal tax rebate will arrive. Federal income tax schedules are also being reduced. Stimulus is on the way. Time is all that the economy needs now.

The recovery will be as uneven as the decline. Some sectors have barely felt a downturn while others have faced near collapse. Some sectors (like telecom equipment manufacturers) may not recover for years, while others may experience better conditions much sooner. Even when recovery begins, we expect it to be at a modest rate. Saturation and over-capacity are ongoing issues. In addition, Europe is slowing, Mexico and South America are slow, and Japan is in a recession. Two to three percent growth is most likely for the next eighteen months.

The consumer is likely to lead the economy out of this difficult period. This is always the case. Capital goods and business investment will likely lag.

One of the truisms about equity market behavior is "don’t fight the Fed." The Federal Reserve has enormous power over the economy and the Fed is now stimulating it. It will not be different this time. The Fed will be successful. The economy and equity markets will recover.

Two steps forward, one step backward, however, is likely to be an apt description of the recovery. The historical precedent for stock market performance after the conclusion of a bear market is excellent. Twelve to eighteen months later, market returns most often have been between 10 to 35 percent. (These calculations are from the lows so do not expect market recovery to get the NASDAQ back to its highs.)

In our January Perspectives, we said that typically only 30% of former leadership stocks come back to lead a recovery phase. This time we wouldn’t be surprised if that number is even smaller. Again, the recovery will be very selective in certain sectors.

The most selective probably will be the technology sector, with only a few former leaders recovering, and some new names coming forth. Early indication points to selected software, service providers and wireless communications firms.

Industrials, health care, financials and consumer discretionary are the sectors that are emerging as leaders. The energy, utility and consumer staple sectors, which have been strong, will probably languish as interest develops in economic recovery. Other sectors look to be average performers.

The Fed is close to completing its efforts to stimulate the economy. Whether one or more minor rate cuts are in the cards is of little further consequence. Real short-term interest rates are now neutral or slightly negative, meaning rates are at or slightly below the inflation rate, especially when including tax benefits.

Besides the effect of Fed policy on short-term rates, and the expectation of a better economy on longer-term rates, inflation is becoming an increasing concern. Over the past twelve months the consumer price index is up 3.6%. The core rate, which excludes food and energy, is up 2.5%. Either measure is not insignificant. The inflation rate has been creeping up. This is something we need to keep our eyes on. Energy prices are cracking and the tight labor market has eased. This may be enough to reverse the trend, but until we know, we will factor that risk into our investment model.

In the April Perspectives we anticipated few, if any, selection changes. This is still the case. However, we are constantly reviewing our holdings, assessing their chances for future performance, and comparing them with alternatives.

We are satisfied with our current sector weightings, but may adjust them as we see more clearly where recovery in the markets emerge. We will further accent strong sectors by incrementally moving assets to them.

We are keeping our target for bond portfolio average life and duration at 5-7 years. We will not increase that target range until our economy is well into recovery. We do not anticipate that to occur for at least another year. The outlook for inflation will also guide future policy moves.

Corporate bonds still offer better value than treasury and municipal issues. This is our preference and as usual, we are only purchasing the higher quality issues.

During difficult markets, many investors lose perspective and commitment to their long term strategies and goals. However, one of the key ingredients to long term success is the consistent application of a disciplined approach.

One of the first inclinations investors have during downturns is to become market timers. They rationalize getting out of the market with the belief that they will buy back at better prices. That almost never happens. In fact, what usually results is selling low and buying high. Market timing doesn’t work consistently. Those investors that think they can buy back at lower prices almost always do so at much higher prices when they feel more confident.

Another inclination is to chase style. If small cap stocks seem to be doing well money moves there. Later it may be international, real estate investment trusts or some other stock category. All that usually happens for these investors is that they chase their tails. Round and round they go making a good move one day and a bad one the next.

A third reaction is for investors to change their investment risk profile. They have an aggressive stance when markets are high, but move to a more conservative one when markets are much cheaper. Doing the opposite is much more profitable. Remember the rule is "buy low, sell high." The time to be aggressive is when prices are cheap.

At Riverplace Capital Management, we have decades of experience within a variety of environments. We employ a disciplined approach. We use our research to determine sector weightings, asset mix, and individual selections, with triggers in place to monitor, trade and rebalance portfolio risk.

If you want the benefits of our experience and history of excellent results, Talk with Us.

Earlier this year, Standard and Poors changed the economic categories in its S&P 500 index to conform to the Global Industry Classification Standard (GICS). There are ten sectors. Some companies’ stocks moved to new categories. Riverplace Capital has realigned its large-cap equity model and client quarterly reports to reflect these changes.

We congratulate our own C. Ronald Belton who is appearing every Monday morning on the Good Morning Jacksonville television show. Look for him on CNBC in the future as well. Ron is an excellent ambassador for Riverplace Capital Management.

Large Cap Stocks (S&P 500) -7.26%

Dow Jones Industrial Average -2.64%

Mid Cap Stocks (S&P 400) +0.46%

NASDAQ Composite -12.55%

Small Cap Stocks (Russell 2000) +6.12%

MSCI EAFE -15.47%

Lehman Corp. Bond Index +6.2%

Inflation +3.6%

(Equity indices are six-month returns excluding dividends)