The domestic stock market managed to post another solid quarterly return despite having its first negative monthly return of the year in June. The S&P 500 returned 2.9% for the second quarter. Unfortunately for diversified investors, the US and Japanese stock markets were the only markets to post positive returns for the quarter. European stocks were down 1.4%, emerging market stocks were down 10%, domestic bonds were down 2.5%, international bond markets were down 3.1%, general commodity prices were down 5.9%, and precious metals were down a whopping 25%. It was a challenging quarter for asset allocators. We think the good news is that investors may finally be focusing on fundamentals and abandoning the “risk on/risk off” mindset.
Most markets were humming along quite nicely through the mid-point of the quarter when Federal Reserve Chairman Ben Bernanke suggested the Federal Open Market Committee was looking into possibly tapering off some of its bond buying activities (quantitative easing) in the coming months. Those comments, and the subsequent statement and press conference following the June FOMC meeting, spooked investors across the globe. Longer-term US Treasury bond yields rose 1% (that represents a price decline of approximately 10% on longer-dated US Treasury securities as bond prices move in the opposite direction of their yields) and global stock markets declined over 6%. Fortunately, bond yields began to stabilize and stock markets recovered some of those losses over the last week of the quarter.
Our clients’ portfolios struggled along with the global stock and bond markets in the second quarter. In fact, the more conservative the allocation the more difficult the quarter as global taxable bond indices returned a negative 2.8% and global stock indices returned a negative 0.25%. On a relative basis clients’ portfolios did benefit from our allocation to non-traditional equities (which actually posted a positive return for the quarter) and to our non-traditional fixed income strategies that, while still negative, did manage to outperform traditional bonds by roughly 1.5%. Our inflation sensitive real asset holdings (natural resources, commercial REITs and infrastructure) were a drag on portfolio returns as inflation expectations continued to decline during the quarter—the Fed’s favorite gauge of inflation, the Personal Consumption Expenditures Index, actually hit a 50-year low during the quarter.
Five weeks of panic selling often leads to many opportunistic pricing dislocations. While we don’t necessarily agree with the magnitude, we understand the rise in Treasury and mortgage yields; but, we are puzzled as to why corporate bond yields rose even more than Treasury yields. The Fed outlined a data-dependent timetable for reducing its bond purchases. Specifically, GDP growth approaching 3%, inflation approaching 2% and unemployment falling below 7%–we think that’s an ideal environment for equity investors; and, if it doesn’t happen the Fed will continue its bond purchases—an environment that heretofore has also been ideal for equity investors. Even with the recent rise in bond yields we would still favor equities and our non-traditional fixed income strategies over traditional bonds.
Not to worry, we remain committed to our mandate to build the least risky portfolios necessary for our clients to achieve their financial goals.
The domestic stock market has demonstrated an uncanny resiliency and resolve of late. The S&P 500 was up 10.6% in the first quarter, closing within 0.5% of its all-time high. This, despite numerous headwinds including a sluggish economy (Q4 GDP growth was an anemic 0.4%), the implementation of the automatic spending cuts which could further weaken economic growth, the still unresolved debt ceiling debate, declining consumer confidence, an Italian electorate that is revolting against Europe’s austerity measures, and the demise of the little island of Cypress which has bank depositors throughout Europe wondering if their savings are at risk of a government-imposed tax. Most of the information flow is signaling caution yet the market surges ahead—what’s up with that?
We think what’s up is that we are in the early stages of a major re-allocation shift among institutional and individual investors. The rise in equity valuations and the decline in bond prices are not due to some newfound euphoria over future economic growth—if that were the case we would expect to see emerging markets leading the pack (down 2% for the quarter), commodities in general (up 0.5%) and particularly economically sensitive commodities such as copper (down 7%) also showing significant gains. Instead, we are seeing the more defensive, higher dividend yielding sectors of the market leading the charge—the Dow Jones Utility Index (4% yield) was up more than 13% for the quarter, the Alerian MLP Infrastructure Index (5.3% yield) was up nearly 20%, and the Bloomberg Mortgage REIT Index (12% yield) was up almost 18%. What’s up is a widespread rotation from bonds to stocks as investors seek out higher yielding assets. The transition makes sense for income dependent investors—intermediate tax exempt bonds are yielding 1.2% and intermediate investment grade corporate bonds are yielding less than 2%.
Our clients’ portfolios performed quite well, on both an absolute and relative basis, in this environment as we have been touting many of these non-traditional higher yielding asset classes for some time now. The global equity portion of clients’ portfolios benefitted from an underweighting in developed international stocks and an overweighting in domestic small- and mid-cap stocks. The returns for both our taxable and tax-exempt bond portfolios were greatly enhanced by their exposure to lower rated high yield bonds. Our holdings of gold and silver as a deflation/inflation hedge, which we were reducing throughout the quarter, was the biggest drag on portfolio returns as precious metals were down more than 5% for the quarter.
With the equity market fast approaching its historic highs it would be tempting to become more defensive. While we wouldn’t be surprised with a modest correction along the way, we believe the overriding upward trend remains intact. Investor asset class rotations, as we are witnessing now, are typically long in duration—they don’t get completed in a few months or quarters, it usually takes a couple years. The headwinds remain but they are also known. Based on the market’s recent performance in the face of some unanticipated shocks (Italian elections and Cypress come to mind), it will take quite a bit to derail this train.
Not to worry, we remain committed to our mandate to build the least risky portfolios necessary for our clients to achieve their financial goals.
The domestic stock market, as measured by the S&P 500, posted a lackluster return for the quarter, but it achieved that return in spectacular fashion. At the mid-point of the quarter, roughly 10 days after the Presidential election, the market was down 6%. The market rallied from that point forward—capped off by a strong closing kick on New Year’s Eve fueled by rumors of a compromise on the Fiscal Cliff negotiations in Washington. Ironically, it was Apple, a stock that was up 65% over the first nine months of the year, which dragged the index returns down for the quarter. As the largest company in the world, Apple had nearly a 5% weight in the S&P 500—its 20% decline for the quarter accounted for all of the index’ decline and then some.
Global stock markets performed much better than the domestic market in the fourth quarter. This was largely due to an easing of concerns regarding the European sovereign debt crisis and rising fears of the domestic Fiscal Cliff. While the S&P 500 was down 0.38% for the quarter and domestic small-cap stocks were up only 1.85%, emerging international market stocks were up 5.58% and developed international markets were up 6.63%. Domestic taxable bonds were up 0.24% for the quarter, municipal bonds were up 0.21%, and taxable international bonds were down 1.04%. Despite all the craziness and the rollercoaster ride the markets gave us throughout the year, 2012 turned out to be a very good year for investors. Domestic stocks returned 16% for the year, global stocks were up 16.8%, taxable bonds were up 4.3% and tax-exempt bonds were up 3.1%.
Our clients’ portfolios benefitted from an increased allocation to small- and mid-cap international equities, as well as our introduction of a new frontier market (Africa, Middle East, etc.) investment in the portfolios. They were hurt by a couple of our higher yielding asset classes, mortgage REITs and energy infrastructure MLPs, that were star performers for us in previous quarters. Much of the damage was due to speculation about rising dividend tax rates, which we felt was being misapplied even if rates had gone higher, but is now a moot point. In any event, both of those asset classes have come roaring back in this first week of the new-year.
The New Year brought a compromise from Washington in one area of uncertainty: future tax rates; and, the markets have rallied on that news. There are still the matters of spending cuts and expansion of the debt ceiling—those discussions will likely get ugly. That said, market fundamentals strongly favor stocks over bonds—the dividend yield of the S&P 500 is 0.5% higher than the yield on investment grade taxable bonds; price-to-earnings multiples for stocks are nowhere near overextended levels; and, inflation pressures are beginning to build as each major central bank devalues their respective currencies. As a result, we will look to use any meaningful equity market pullback over the next couple months as an opportunity to reallocate from fixed income-like asset classes to global equities and real assets. We remain committed to our mandate to build the least risky portfolios necessary for our clients to achieve their financial goals.
Chief Investment Officer
Disclaimer and Disclosures
This report is provided for informational purposes only, and does not constitute any offer or solicitation to buy or sell any security discussed herein. All opinions expressed and data provided herein are subject to change without notice. All investments involve different degrees of risk. You should be aware of your risk tolerance level and financial situations at all times. Past performance does not guarantee future results.
The stock market keeps chugging along. Despite all the notable headwinds: sovereign debt crisis in Europe, Fiscal Cliff here at home, hard economic landing in China, severe recession in Europe and a slowing domestic economy, the global equity market has managed to advance 13.4% year-to-date and the domestic market, as measured by the S&P 500, has increased 16.4%. A year ago the market was concerned about pretty much this same list of headwinds—since then the global equity market is up nearly 22% and the S&P 500 is up over 30%. The strategists appearing on CNBC and Bloomberg would describe this phenomenon as the market climbing a “wall of worry”. The markets’ ability to climb a wall of worry reflects investor confidence that these issues will be resolved, presumably favorably, at some point. We have no doubt these worries will eventually be resolved; we aren’t sure that they will all be resolved favorably; but, we are pleased with what the markets have given us these past twelve months.
The European Central Bank’s announcement that it would buy sovereign debt in the open market, with the circumspect approval of the Germans, reignited the market rally. This move essentially replicates our own Federal Reserve Bank’s first round of quantitative easing. Not to be outdone, the Fed announced after its September Federal Open Market Committee meeting another round of quantitative easing as well. In keeping with the normal numbering sequence this would be QE3, but given the indefinite time horizon and unlimited size of this round of quantitative easing we have dubbed it “QE Perpetuity”. With the major central banks providing the stimulus, the “risk on” trade was back and most markets saw meaningful advances in the third quarter. Domestic small-cap stocks were up 5.3%, large-cap stocks were up 6.3%, developed international stocks were up 6.9% and emerging market stocks were up 7.7%. Commodities were up 11.5%; and, even bonds, which typically move in the opposite direction of stocks, had a strong quarter with domestic investment grade corporate bonds up 3.4%, high yield bonds up 4.4% and European sovereign bonds up 5.1%.
While we began the quarter with a more cautious posture than we’ve had in the past few years, our clients’ portfolios still participated pretty fully in the market rally. Much of this was due to our core allocation to real assets, specifically precious metals, natural resources, energy infrastructure and commercial REITs. As a group, our real asset holdings were up 12.8% for the quarter. These investments are much more defensive than the overall stock market but they tend to outperform stocks, as they did this past quarter, in periods in which inflation expectations are on the rise and/or the dollar index is in decline. Longer-term inflation expectations increased 0.5% and the dollar index declined 3% during the quarter.
We became much more constructive toward the market with the announcement of QE Perpetuity and have since reallocated much of the cash we were holding. The Fed is basically abandoning its dual mandate of controlling inflation and supporting growth and replacing it with a single mandate to support growth. The European Central Bank is trying to do the same; and, we expect the Chinese central bank won’t be far behind. The clear near-term beneficiaries of an “inflation be damned, we need growth” policy are risk assets such as stocks, commodities, real assets and certain high yield debt instruments. There are still a number of speed bumps between now and the end of the year which will test the market’s resolve to continue climbing this wall of worry; but, we believe the trajectory remains pointed higher. Not to worry, while we want to make sure our clients’ portfolios continue to participate in any further moves up, we remain committed to our mandate to build the least risky portfolios necessary to achieve our clients’ financial goals.
Jim Robinson Partner, CEO & CIO—Telemus Capital Partners