Stocks charged out of the gates during the second quarter, rallying on stronger-than-expected earnings and hopes that the worst of the recession was over. The S&P 500 shook free from six consecutive losses, its worst run since 1970, with its steepest advance in eleven years. The benchmark closed on June 30 up by more than a third from its March 9 twelve-year low. The Dow surged in its biggest gain since 2003.

A proxy for financial stress and benchmark to $360 trillion in global assets, the London interbank offer rate for three-month dollar loans (Libor) fell thirty-eight consecutive days through May 26. After touching 4.82% in the heat of last year’s market collapse, Libor ended the second quarter at a record-low. Cheaper lending rates fused with growing investor interest to unlock a rush of corporate borrowing. Speculative grade issuers sold almost $22 billion in junk bonds in May, the best month since June 2007.

Cornerstones of a prospective recovery, the U.S. labor and housing markets deteriorated at a slowing pace. The Commerce Department reported 345,000 nonfarm jobs lost in May. While this was the fewest job losses in eight months, it was enough to drive unemployment to 9.4%, a twenty-five-year high. The National Association of Realtors reported a back-to-back increase in existing home sales in April and May, the first in four years. Still, fresh inventory poured onto the market. Foreclosure filings topped 300,000 for the third month running in May.

The slash and burn approach to corporate earnings forecasting went into retreat last quarter. In comparison to 4Q08 and 1Q09, when consensus estimates dropped precipitously, expectations for 2Q09 have held fairly firm. According to Thomson Reuters, as of June 26, Wall Street analysts expected a 35% drop in 2Q09 S&P 500 profits. On April 1, a 32% drop was expected. Realized, this would mark eight consecutive declines, the longest contraction on record.

Two firms were pulled from the Dow, victims of the recession: General Motors was once the world’s largest automaker and Citigroup was once the largest bank.

The Allianz NACM Growth Fund lagged the Russell 1000 Growth Index during the period. Performance was hindered by a weakness in our earnings-based and long-term momentum factors, a result of investor rotation into stocks based on distressed price levels, irrespective of their poor near-term earnings growth forecasts. Security selection in the Consumer Discretionary, Consumer Staples, and Energy sectors were considerable drags on relative returns, as was the portfolio’s overweight to Health Care. Select holdings in Information Technology contributed positively.

Financials were the far and away leaders of the large cap growth space during the quarter as many demonstrated the ability to raise capital despite earnings projections that lack compelling cases for near-term profits. Energy and Industrials also rallied, along with the prices of their underlying commodity counterparts, on the belief that the global recovery will likely be led by developing countries, particularly China, where infrastructure construction has resumed. Investors rotated away from defensive names such as Health Care and Consumer Staples during the quarter, which they had flocked to earlier in the year, in favor of cyclicals that will benefit from an economic rebound.

Pulte Homes was the biggest performance detractor of the period. The company, which is the second-largest homebuilder in the US, suffered from write-downs of land and inventory as new home sales continued to disappoint and data released in May showed that the rise of foreclosures in the first quarter were the highest in history. Apollo Group, the parent company of University of Phoenix, was another significant detractor. The company was downgraded by several analysts during the quarter over industry concerns stemming from the new administration’s Department of Education appointment. Concerns stem from impacts relating to allowable marketing initiatives, rules for how quickly students can withdraw from the schools, and disclosure of student loan default rates, all of which are expected to be negative from an operations and profitability perspective.

Sohu.com, an internet software company that focuses on the Chinese marketplace, led portfolio performance during the quarter as the market rewarded its earnings that had nearly quadrupled over the prior year and beat street expectations, a result of its successful entry into the multiplayer fantasy game space. Online gaming as whole has benefited from the economic slowdown as consumers have increasingly sought budget-friendly, fantasy-like escape entertainment; Sohu.com has further benefited as many companies have sustained their web advertisement budgets in recognition of this consumer trend. Computer-maker Dell was another leader, as its stock was buoyed by the belief that the company, with its low-cost structure, will benefit as companies begin to invest in their technology infrastructures to boost productivity. Additionally, investors reacted favorably to rumors that Dell is looking for an acquisition target to grow its business.

At the end of the period the portfolio, based on bottom-up stock selection, had an overweight exposure to the Information Technology and Energy sectors relative to the benchmark, and an underweight to Health Care, Consumer Staples, and Materials.

With global stock markets and commodities up sharply since March, investors are asking whether the worst is behind us. Certainly, authorities worldwide have pulled out all the stops, using monetary and fiscal policies and government balance sheets to thaw frozen credit markets. Companies have started to raise capital again, and credit spreads have fallen by half from the record levels seen in 4Q08. As a result of these actions, we have seen stabilization in the rate of economic decline around the world, and the large contractions witnessed in 4Q08 and 1Q09 should not be repeated. However, unemployment will likely continue to rise, as it tends to be a lagging indicator, and the de-levering of the American consumer will probably take some time. We would prepare for a prolonged period of below-potential growth. We also expect higher tax rates, as we have already seen in the U.K. and proposed in the U.S., and higher government involvement across the economy, from financial services to health care. All this, we believe, will be a drag on economic growth.