Quarterly Perspective for 1Q11
Stocks posted another gain during a very volatile first quarter of 2011. The U.S. stock market surged to a gain of more than seven percent through February 18th, before concerns about inflation and an economic slowdown cut that gain in half over the next two weeks. Then, just as stocks began to recover, Japan was hit by a devastating earthquake and tsunami. This push briefly erased all the market’s year-to-date gain. Eventually investors realized that the global financial impact of the disaster in Japan would not be as bad as feared. The U.S stock market recovered to finish with a quarterly gain of 5.9%. While short of the highs we hit mid-quarter, it was nonetheless very impressive given the host of challenges the market faced.
International stocks did not perform quite as well. Emerging market stocks were hit by rising food and energy prices. Europe struggled to come to terms with debt problems among some of its members. Japan obviously had a very tough quarter. The United States was (as one market pundit put it) “the best house in a bad neighborhood”. Foreign markets did recover late in March as the dollar headed south on fears of a government shutdown. For the quarter, foreign stocks rose 3.4%. Emerging markets, down as much as 8% at one point, surged at quarter end to a 2% gain. European stocks were up a surprising 6.4%. As one might expect, Japanese stocks fared the worst with a loss of about five percent.
Bonds gained less than a half of one percent. Low yields and rising interest rates is about the least favorable combination for most fixed income instruments. High quality, longer duration bonds provide a nice hedge against economic weakness, but other than a brief spike in March (as investors became concerned about the global effects of the Japanese tragedy) these bonds slid in the face of a recovering economy. On the other hand, lower quality corporate bonds (which are more sensitive to economic strength than interest rates) were able to post a gain of about 3.8%.
We rebalanced portfolios where necessary to allow for rising interest rates and increase exposure to large cap U.S. stocks. We also added to the health care sector and replaced several underperforming funds. For example, the Fairholme Fund was Morningstar’s Fund of the Decade from 2000 through 2009. Unfortunately, its -2.3% loss in the first quarter placed it in the bottom 1% of funds with similar objectives. Our patience is obviously longer than three months, but it is not infinite (especially when some of its competitors gained seven percent of more).
As always, it is impossible to predict what the markets are going to do. Bonds would seem to be easier to forecast since we know the economy has been growing and we expect the Federal Reserve will keep its promise to end quantitative easing at the end of June. The only way bond yields won’t rise is if the economic difficulties elsewhere in the world (Japan, Europe) spill over here. On the stock side, the path of least resistance (at least in the short run) seems higher. This is how we see the indicators right now:
- Liquidity: Positive. There is a lot of cash out there, and that correlates well with strong markets.
- Valuation: Neutral. On a price-to-reported earnings or price-to-cash flow basis stocks are on the expensive side; versus bonds or money market yields stocks are cheap.
- Sentiment: Neutral. While slightly over-bought in the short term, we have not seen the strong, steady inflows from individual investors that is typical of market peaks. In fact, every time we get a sell-off (even the brief six percent dip this past quarter) individual investors quickly become net sellers and professional investors become net buyers.
Some sectors of the stock market, most particularly those that are involved in providing energy, raw materials, or agricultural goods to the Pacific Rim, have done very well and are pricey at this point. Other areas of the market have done comparatively little over the last two years and appear to have a fair degree of upside left.
Commentary – Cyclical Versus Secular
In order to understand how the stock market moves you first need to understand the economic (business) cycle and then you need to understand each industry’s relationship to the cycle. Here is the “Cliff’s Notes” version:
The economic cycle refers to the cycle of business and credit expansion and contraction around a general growth trend. One full cycle usually lasts from three to six years, and there are four stages. At Stage 1 of the cycle (usually thought of as the beginning) the economy is growing at a below trend rate. Interest rates are typically low because credit demand is low. As credit becomes available at low rates, businesses find it attractive to finance expansion. Economic growth picks up. As we enter Stage 2, fears of sliding back into recession fade, but interest rates remain low. At some point, economic growth is above-trend, and with credit demand rising, the cost of credit (interest rates) rises. This is Stage 3. In Stage 4 the cost of credit is greater to business than the expected return, so business cuts production. The economy falls into recession. The cost of credit falls. Soon we are back to Stage 1.
The market cycle is related to the economic cycle. Stocks typically move AHEAD of the overall economy. The stock market is already rising at Stage 1 because investors anticipate the benefits of low interest rates. Stocks extend their gains during Stage 2, but where smaller and consumer discretionary stocks usually lead during Stage 1, stocks in industries that are most sensitive to the economic cycle tend to do best in Stage 2 (though all sectors go up). Certain industries begin to turn lower in Stage 3 even though the economy is still growing because investors anticipate rising interest rates. Their preference turns to larger companies and stocks in industries they believe might be immune to the cyclical downturn. In Stage 4, investors want companies that have very little economic sensitivity (health care, utilities, and consumer staples). Most stocks decline in Stage 4.
Now we will discuss the term “secular,” or long term, cycle. It refers to the concept that some industry cycles are a lot longer (15-20 years) than the typical business cycle. Industries in a secular bull market typically experience only modest declines in Stage 3 and 4, while those in secular decline may not gain much even in Stages 1 and 2. For example, the home construction industry tends to move in long waves. It is in secular decline right now, after a fifteen year bull market (1990-2005). While low interest rates have made home ownership as affordable as it has been in decades, this has had almost no impact on economic activity or the stocks in that sector. On the other hand, the mining and materials sector is in a long wave uptrend after twenty years of decline (1980-2002). This industry has experienced rapid growth this decade because expansion in emerging markets kept prices and demand high. Stock price gains in this industry have tended to be much greater than those of the overall market.
Investors tend to assume that each company and each industry will rise and fall with the economic cycle. That is not necessarily true. The great investment opportunities come from discovering secular moves that the market perceives as cyclical. One example would be buying energy and commodity stocks in early 2009 after they had plunged 50-70%. The other great opportunity is getting into industries where the trend is changing from secular bear to secular bull. Imagine buying gold mining stocks in 2000 when gold was under $270 per ounce. Unfortunately, it is far more common to see the opposite – paying a secular growth price for stock that was simply in Stage 3 of the economic cycle. Or worse, buying into a secular growth industry just as the long wave was ending. For example, think about how much more money was invested in technology in 1999 versus 1989, or real estate in 2005 versus 1995.
The reason for writing this is to put today’s market in context. Investors have a very high degree of confidence in the energy sector right now. Crude oil is currently north of $120 per barrel, approaching the 2008 all-time high of $147 yet there is (again, like 2008) no shortage. High prices lead to increased production. If some of that production is being held off the market for speculative purposes, prices can still rise short term. At some point, however, it costs too much to store that production versus the expected profit. Supply floods the market and prices plunge. We are seeing similar speculative hoarding in other commodities such as copper because many believe that Chinese demand for materials is limitless. We can’t tell you if this trend will last another three days or five years. We can say, however, that energy and materials are high return, high risk propositions right now. That is okay for some people, but it is not the way we prefer to invest.
Conversely, health care is an industry that has been in secular decline since its heyday in the late 1980s and 1990s. Declining growth rates, government regulation, patent expiration, and other factors have contributed to a sharp compression in the earnings multiple of companies in this industry. At this point however, you have cheap valuations, nice dividends, and a growing customer base as the population ages. We see this as a modest return, low risk situation. This is the kind of opportunity we look for.
It is difficult to fully do justice to the concepts of economic, market and secular cycles in just a few paragraphs. If you’re interested in learning more about this and other topics you can keep up with our thinking on our blog at www.trademarkfinancial.us/blog or follow us on Twitter at TrademarkFinMgt. Our general thesis is that the economy is in late Stage 2 of the business cycle. Interest rate pressures are already being felt in Asia, Latin America, and Europe, so Stage 3 can’t be far off. Interest rate sensitive stocks are more vulnerable now than more economically sensitive ones, which will likely be supported by money coming out of the bond market. This makes buying into the stock market, while still generally favorable, an increasingly risky proposition right now.
Past Performance is no assurance of future results.
All index data provided by Telemet Orion or Morningstar Advisor Workstation. Numbers do not reflect fees, brokerage commissions or other expenses of investing.
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 S&P 500 Index per Morningstar
 MSCI EAFE Net Return in US Dollars per Morningstar. The foreign index performance numbers that follow are also from MSCI per Morningstar (Emerging Markets, Europe, Japan)
 Barcap U.S. Aggregate Bond Index per Morningstar.
 Barcap U.S. High Yield Corporate Bond Index, per Morningstar