Liz Ann Sonders
Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.,
Brad Sorensen
CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research, and
Michelle Gibley
CFA, Senior Market Analyst, Schwab Center for Financial Research 

Stock markets rallied nicely after trading near the bottom of their recent wide range. Earnings season is now largely in the book, and the mostly positive results we saw helped coax some investors back into the market. However, a large amount of trepidation remains, as evidenced by the sharp market decline following the August 10 Federal Open Market Committee (FOMC) meeting.

Companies remain relatively cautious, while economic data remains mixed, clouding the picture for still-skittish investors. We remain moderately bullish, as the economic recovery now seems fully entrenched, and markets seem to be adjusting to a slower rate of growth after the sharp V-shaped recovery. It wouldn't be surprising, however, to see another decent pullback after the action seen in July.

We're also keeping a close eye on the yield curve. It remains relatively steep, though it has flattened some as longer rates have declined. This indicates continued economic growth; however, yields across the curve remain near historically low levels. This implies at least some level of fear continues as investors seem content to loan the government money for very little return, in exchange for the safety inherent in US Treasuries.

Vacations impacting volume
August is traditionally one of the slowest months of the year as many on Wall Street take their last summer vacations before school starts back up. As a result, volume is typically lighter than normal, which can exaggerate moves and lead some investors to read more into market gyrations than they should.

We caution investors against reading too much into any short-term move, and even more so during low-volume periods. Equity investing should be done with a longer-term perspective.

The past two months have shown why it's foolhardy to attempt to trade short term, because just as the market was starting to breach some supposedly important technical support levels and international events were worsening, the market started to rebound, posting strong returns in July. Consistently being able to "time" such moves or anticipate events such as the Greek riots, the Fed's emergency decisions, political changes, bank stress tests or natural disasters is next to impossible.

We believe it's important for investors to always have their longer-term investment plans in mind (consistent with their risk tolerances and return requirements). Use market fluctuations as opportunities to rebalance, as necessary, to maintain a diversified portfolio.

Glass half full … or half empty?
As economic data continues to flow, it's important to keep an eye on developments. Data continues to tell a muddied story, with bulls and bears both able to grab onto different reports, or parts of reports.

While the headline number on many data sets is important, it can be the underlying components of reports that tell the more accurate story. The Institute of Supply Management (ISM) reports, both manufacturing and nonmanufacturing, are a perfect example.

Both reports continue to show economic expansion, with the manufacturing index easing to 55.5 in July from 56.2, while the nonmanufacturing index rose to 54.3 from 53.8. Looking inside the report tells a more complete story.

New orders, which show what future activity may look like, fell back on the manufacturing side to a one-year low, but still in expansionary territory at 53.5. Although that's somewhat disappointing, it continues to show growth, and was offset by the nonmanufacturing new order reading, which rose to 56.7 from 54.4—indicating increasing activity in the much-larger service sector.

Housing still a problem
Although much economic data continues to show economic improvement, job and housing data continues to be concerning. On the housing front, the data has been distorted by the expiration of the federal homebuyer tax credit, but that distortion should be fading, and June pending home sales still fell 2.6%. While much better than the 29.9% drop we saw in May immediately after the tax credit expiration, it still missed expectations of a positive reading.

Although mortgage rates remain historically low, housing continues to have trouble gaining traction. We believe we're in a long bottoming/stabilization process, but that a sharp rebound in the all-important sector is unlikely.

Jobs continue to garner much of the attention on Main Street and Wall Street. The recently released July labor report showed private payrolls increased by 71,000, still relatively anemic, while the unemployment rate remained at 9.5%. Somewhat encouragingly, the average workweek ticked up to 34.2 hours from 34.1 hours in June.

However, there's hope on the labor horizon as leading indicators continue to show improvement. Temporary employment had shown strong gains before easing slightly last month. Meanwhile, the employment component of the ISM Manufacturing Index rose to 58.6 from 57.8, and the same indicator in the nonmanufacturing report rose to 50.9 from 49.7, indicating expanding employment in the service sector.

Employment indicators provide hope

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Source: FactSet, ISM, as of August 11, 2010.

Can the government and the Fed inspire confidence?
We believe part of the issue holding back hiring is continued uncertainty in corporate America—especially among smaller businesses. Companies continue to hold large cash balances on their books, indicating continued caution in the uncertain environment.

Companies need to put cash to use

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* Cash includes: check deposits and currency, commercial paper, foreign deposits, money market fund shares, mutual fund shares, time deposits and savings, and government agency and Treasury securities. Source: FactSet, Federal Reserve, as of August 11, 2010.

Certainly, part of the caution can be traced to uncertainty surround the political winds in Washington. Concern about spending at both the federal and local levels and how that affects economic activity appears to be prevalent.

States and local governments are having to slash budgets, while laying off workers—contributing to the jobs problem—while the federal government grapples with extending stimulus or fighting burgeoning deficits. With new health care legislation, new financial regulations and uncertain tax policy after December 31, it's difficult for businesses to confidently invest in the future.

The Fed also continues to try to inspire companies and individuals to borrow, invest and spend—moving the money multiplier off its extremely low levels. During the most recent meeting, the FOMC reiterated its extremely accommodative stance and indicated that it would remain in place for some time, while downgrading its current view of the economy.

There's even been increased chatter about the possibility of a renewed round of quantitative easing, although we think that's relatively unlikely. Read more about the most recent Fed decision and why we think an unconventional move may be appropriate.

We continue to watch both the Fed and the government's actions with intense interest as their decisions stand to weigh heavier on the economy than typically is the case.

China's economy and market leads global trends
Of course, we live in a global economy now, and the Fed has to balance its decisions with policies in other major countries. China led out of the recession, but growth in China has slowed due to: 

• Waning stimulus. 
• Increased focus on energy efficiency goals forcing factory shutdowns. 
• Crackdown on property speculation. 
• Tougher comparisons. 
• Slower imports of goods that are inputs for future exports.

Leading indicators of economic activity imply further slowing. Since China has been a major contributor to global growth, trends in China tend to lead the globe.

China's economy leading

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* The Organisation for Economic Cooperation and Development is an international economic organization comprised of 32 countries. Source: FactSet, OECD, as of August 11, 2010.

Despite worsening economic trends, the Chinese stock market has begun to outperform. Market liquidity improved after the completion of the world's biggest initial public offering in four years for Agricultural Bank of China Ltd on July 15, and the Shanghai Composite outperformed the S&P 500® index by 8% during the subsequent three weeks.

Policy could be less restrictive going forward, as gross domestic product (GDP) growth in the fourth quarter could approach the 8% target. As we've been noting, news flow could potentially become a positive catalyst rather than a negative, and the Chinese stock market has likely started to anticipate this change.

The Chinese economy could be stabilizing: company surveys indicate improved sales sentiment, imports of some commodities used in construction have increased, and on a seasonally adjusted basis, the manufacturing Purchasing Managers Index in July actually increased.

West meets east
Additionally, there's been increasing discussion regarding boosting spending to develop western provinces, with quotes attributed to officials from the National Development and Reform Commission, the National Statistics Bureau and the central bank.

The western regions of China are rich in natural resources, but the infrastructure is underdeveloped—creating high costs of transporting the commodities that China needs for continued urbanization.

China seeks to increase income equality in western regions with the coastal east. Eastern regions have benefitted most from China's growth, accounting for more than 90% of exports, and income levels in the east have risen faster than in the west. As income disparities can risk the potential for social unrest, China's government-led growth will be increasingly focused on the west.

Coastal regions have experienced labor shortages and rising land costs, increasing the attractiveness of inland locations for companies—manufacturer Foxconn is reportedly moving about 200,000 workers in its first stage of relocation.

Stress tests—not just for Europe, but also in China
Given that the banking system in China lacks transparency, is primarily state-controlled and lent a record $1.1 trillion in 2009, it's an easy target for the bears.

China's banking regulator—the China Banking Regulatory Commission (CBRC)—has been stepping up oversight this year, ordering capital ratio increases, improved lending standards, higher provisions for loan losses and increased deposit ratios. Additionally, it has been conducting property-related stress tests and delving into the local government and off-balance sheet assets of the banks.

The stress tests of property-related loans are attracting media attention. The CBRC conducted two tests: The first round assessed the impact of a 30% potential price decline, which reportedly also included an interest rate rise of 1.08%. This resulted in an estimate that nonperforming loans would rise by 2.2%. For perspective, the CBRC said that NPLs were 1.3% at the end of June, relative to a 3%-4% range for large US banks.

However, the second test uses a 60% price decline, which raised some eyebrows. The government clarified that this isn't its forecast, but that it was intended to be a worst-case scenario, and that loans from only seven cities with outsized price gains face this second test. We point out that incomes have risen faster than home prices during the past decade, and that there remains a deficit of housing supply, making a broad 60% price decline seem unlikely.

Regarding local government loans, the CBRC released its first estimate of troubled loans at 23%. Estimates of losses range from $100 billion to $200 billion. However, banks were ordered to issue loans as part of the 2009 stimulus, and to the extent that the government has to absorb losses, this can be thought of as stimulus payout.

Our outlook for the Chinese market does face the risk of another round of capital raising to be forced upon the banks to strengthen their balance sheets, diverting funds from existing equities.

Central banks in Europe and Japan quiet, for now
The Fed moved to keep the balance sheet constant, delaying exit strategies. Meanwhile, the European Central Bank remains opposed to providing stimulus, even in the face of a market riot over government debt in the second quarter.

We're less certain about actions the Bank of England or the Bank of Japan (BoJ) will take going forward. Fiscal austerity enacted in the United Kingdom is likely to cut into already weak growth, and the BoE has been on hold. However, conditions in Japan are downright grim, with domestic demand weak and exporters under pressure.

The yen is currently at a 15-year high relative to the US dollar, hurting the profits of exporters. An aging population and constant deflation creates conditions for delayed or low levels of spending in Japan. Meanwhile, on a relative basis, the BoJ response to the crisis was much smaller than other major central banks.

Japan's response has lagged

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* Rebased to January 1, 2007 = 100. Source: FactSet, Federal Reserve, European Central Bank, Bank of Japan, as of August 11, 2010.

While it would be beneficial for the yen to weaken, it's unclear whether more money supply would be an adequate fix for what ails Japan without it being unbearable in size.
Increased fears of a double-dip recession could create demand for the safe-haven status of the US dollar. However, we believe global growth will remain positive and avoid a double-dip.

While there are many factors that influence currencies, movements are relative. As fears of a double dip wane and with the Fed's exit potentially later than other central banks, the US dollar could resume a downward trend.

When the US dollar falls, investments in other currencies have the potential to outperform, and companies with international operations benefit as their goods become less expensive on a relative basis. We remain constructive on the relative attractiveness of emerging markets due to their better growth prospects.

Important Disclosures

The MSCI EAFE® Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the United States and Canada. As of May 27, 2010, the MSCI EAFE Index consisted of the following 22 developed market country indexes: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom.

The MSCI Emerging Markets Index^SM is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. As of May 27, 2010, the MSCI Emerging Markets Index consisted of the following 21 emerging-market country indexes: Brazil, Chile, China, Colombia, the Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand and Turkey.

The S&P 500® index is an index of widely traded stocks.

Indexes are unmanaged, do not incur fees or expenses and cannot be invested in directly.

Past performance is no guarantee of future results.

Investing in sectors may involve a greater degree of risk than investments with broader diversification.

International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.

The information contained herein is obtained from sources believed to be reliable, but its accuracy or completeness is not guaranteed. This report is for informational purposes only and is not a solicitation or a recommendation that any particular investor should purchase or sell any particular security. Schwab does not assess the suitability or the potential value of any particular investment. All expressions of opinions are subject to change without notice.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.