Market Perspective, Mark Carlton, CFA
I wrote back in December that rising bond yields threatened the cyclical bull market in stocks. Over the next seven weeks bonds stabilized, allowing the stock rally to resume. The inability of bonds to recover more than 20% of their October to December losses suggested bonds might have another leg down. This commenced the first week of February. This bears watching, especially as the rally in stocks is already overextended. The 10 year has touched 3.75%. In June 2009 and April 2010 the 10 year actually bounced off 4%, the decline from those levels taking pressure off the stock market and eventually setting the stage for the next rally.
The crises in several Middle East countries are one of those things that aren’t significant for investors until they are. What I mean by this is that whatever happens in Tunisia, Egypt, Bahrain, and Libya are not significant for most global investors IF THEY REMAIN CONTAINED THERE. The more they spread, the more they could affect places that would have an impact on all investors. At some point, you approach a tipping point where investors go from ignoring a situation to hedging it to eventually fully discounting it. With the oil and precious metals markets’ strong moves in recent days, the fear level is rising. Stocks are going to have to begin discounting what could go wrong in terms of oil and geo-politics, and that means a modest decline.
There are two ways to look at the stock market. One is as a “top-down” strategist and the other is as a “bottom-up” stock picker. The rally since last fall has been led by strategists, who have argued that easy monetary policy in developed markets (as opposed to emerging markets where inflation has authorities tightening credit) would push markets up. Furthermore, stronger signs of recovery would shift assets in developed markets from bonds to stocks as bond yields would not compensate investors for rising inflation risks. And so it has been. This scenario, frankly, has been much better for indexers than stock pickers. Top-down strategists see this scenario continuing, as there seems to be little prospect of the Fed changing policy anytime soon. Increasingly, however, the stock-picker community is protesting that they can’t find much value at these levels. I did a little research on Value Line and their metrics show valuation very close to levels we saw in the fall of 2007. The yield on the S&P 500, which almost reached 4% in March of 2009, is back down to 1.8% (1.6% was the September ’07 low). Price to earnings and price to cash flow ratios are saying the same thing. Basically, the Fed has driven investors into risky assets (today either you are momentum investing or you are lagging). This trade will persist until it doesn’t and there could be very little warning of the change.
A CFA© by the name of Jane Li did an interesting study in an attempt to discern where active investing beats passive investing and where it does not. She came into the study without preconceived notions, so I trust her conclusions even though some were contrary to my experiences (in both directions). Among the conclusions:
- Active managers have done decidedly better in Asia but markedly worse in Latin America. Active management is superior for emerging market debt.
- Passive management is significantly better in all areas of municipal bonds.
- Active managers do a better job in most diversified foreign sectors, large and small, growth and value.
- Passive management is preferred across all maturities of government bonds.
- The data is pretty neutral across the U.S. equity spectrum. I expected large caps to favor passive managers and did, but fairly mildly. I expected small companies to go to active managers, but only in small cap growth was the preference strong. Small value actually had a slight passive tilt.
- In sectors, Energy, Consumer Staples, Precious Metals, and Health were active, while you were better off indexing Utilities, Consumer Discretionary, and Commodities.
- Passive managers did better in the high yield bond space.
My final thought is this; according to John Mauldin’s (www.johnmauldin.com) latest commentary high yield bonds are trading at an average price of 104 (to yield 6.74%). At the bottom of the market, high yield bonds traded at an average price of 58 to yield close to 20%. Bottom line, investors are not being paid for the risk. You can make incrementally more money in high yield bonds if conditions remain ideal, but at some point the pendulum starts moving in the other direction and you will lose money (in junk bonds relative to treasuries) a great deal faster. Moreover, treasuries give you the benefit of diversification versus your stock portfolio whereas lower grade corporates do not. Everybody including Bill Gross has come out on record recently as to how much they hate government bonds right now so a counter-trend rally is likely.
Past Performance is no assurance of future results
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