Monday Morning: Rally might be all smoke and mirrors

I don’t know about anyone else, but I started craving a cigarette right after I opened my second-quarter portfolio statement – and I don’t even smoke.

In case you missed it, the Standard & Poor’s 500 stock index catapulted 15.4% during the quarter ended June 30. To put that in perspective, it was the ninth-best quarter since 1940.

Here we are, midway through the second-quarter-earnings season, and I’d be willing to bet that more than a few executives are kicking back right now with a pack of Luckies.

As of last Monday, with 330 members of the S&P 500 reporting, 65% of public companies beat analysts’ earnings estimates, 22% matched those expectations, and 12% missed them, according to Thomson Financial/First Call in Boston.

The big question, of course, is whether we’ll get to romp again in the third quarter.

The answer, I’m afraid, is that it’s not likely.

Still, if history is any sort of a guide, the quarter may not be all that bad.

Jeffrey Knight, chief investment officer on the global asset allocation team at Boston-based Putnam Investments LLC, has taken a close look at what typically happens after a strong quarter.

Optimism can linger

After a quarter that has jumped 12% or more, he has found, the average performance of the S&P 500 in the following quarter is 5.44% – significantly above the S&P 500’s 3.22% average quarterly gain since 1940.

The quarter after that, the index has historically gained an average of 3.7%.

“What that says is that when the market changes its mind, those changes tend to last a while,” Mr. Knight says. “Optimism and complacency and good feelings can actually last quite a while.”

Of course, that isn’t always the case.

Consider what happened after the second quarter of 1975, when the S&P 500 posted a 15.36% return. The following quarter, the index plummeted 10.95%, only to stagger back in the fourth quarter with an 8.64% gain.

Indeed, there’s plenty of reason to be cautious.

For starters, the economy can’t quite seem to decide whether or not to go forward with a full-fledged recovery.

In addition, the stock market isn’t exactly cheap – despite what the so-called “experts” are saying these days.

proceed with caution

The average price-earnings ratio for S&P 500 companies, based on one-year forward profits, stands at 18.9%. Compared with the historical average of 14%, this leaves stock prices fairly well overvalued.

“It is wise to treat an advance like this with some degree of caution,” says Mr. Knight, who readily concedes that he is expecting a “low average return” environment in the months ahead. “At a minimum, investors should take advantage of a move like this to rebalance their portfolios.”

For the foolishly optimistic – that is, those still expecting the S&P 500 to do even better this quarter than last – one word of caution: Fuggetaboutit!

It’s happened only once since 1940. That was the first quarter of 1943, when the S&P’s 19.82% return beat the previous quarter’s 12.4% return.

For the foreseeable future, stock market gains are likely to be a little less exciting, if not a little dull.

As for the recently ended second quarter, I suppose, like the memories of many torrid affairs, the gains will simply fade into the recesses of my mind – remembered, if I’m lucky, as a spring fling I once had.

Frederick P. Gabriel Jr. is a reporter in the Boston office of InvestmentNews.