Stocks rallied sharply in the last week of the second quarter to finish relatively flat. The quarter had started strong for stocks but gave way in May over deep concerns about the slowing U.S. economy and a potential debt crisis in Europe. There is a strong seasonal tendency for rallies to fizzle out in late April or early May and then a summer rally to lift the market again in July. It doesn’t work every year, but traders are well enough aware of it that when they saw the market decline in May they were prepared to expect the July bounce. When markets got a little bit of good news on the June 27th, the Dow rose more than 100 points. Traders wanted to make sure the ship didn’t sail without them (so to speak) so they continued to buy the rest of the week. The decline of a little over 7% (from April 29 to June 24) was all but erased by July 1.
Our warning in the last Quarterly Perspective about the energy sector getting overly optimistic proved prescient, as energy (-4.6%) was one of the two worst sectors over the past three months (along with financial services, -5.9%)[i]. Health Care and Utilities, two sectors which tend to perform best when the economy struggles, led the way with gains of 7.9% and 6.1% respectively[ii]. Overall the S&P 500 gained 0.1%[iii]. World markets were modestly better, with the overall index up 1.5%[iv]. Despite concerns about Greece, Portugal, and Ireland, European stocks (+2.4%)[v] once again outperformed emerging markets (-2.5%)[vi]. Investors have to remember to look beyond the headlines; interest rates were rising in the emerging markets on inflation concerns while they were stable in most of Europe due to sovereign debt fears. Rising interest rates tend to be harder on stocks than economic concerns.
Bonds responded very well to the slowdown in the economy. Overall bonds gained 2.3%.[vii] The best performing sector of the bond market was municipal bonds (up 3.9%)[viii]. Muni bonds had a horrible fourth quarter of 2010 after a prominent analyst warned of massive defaults, but investors have come to realize that those dire forecasts were at the very least premature. The worst sector of the bond market was high yield corporate bonds (1.0%)[ix]. They tend to perform more like stocks and they also declined modestly when the economy hit a rough patch in May.
We looked to add to defensive sectors opportunistically last quarter. Health care stocks tend to be a good place to be when the economy slows because health care usage is not economically sensitive. We eased back on small company stocks because they usually lose more during market downturns. Lastly, we replaced or reduced fund positions where the fund was substantially lagging. That was the case with both Fairholme and Janus Overseas. Both are past winners of Morningstar’s Fund of the Year award and Fairholme actually was Fund of the Decade for the period 2000 through 2009. As the saying goes, however, you can’t eat past performance. Both funds have underperformed similar funds this year by a wide margin and we felt the manager underperformance was large enough, even in light of their past track record, to warrant action. That is one of the advantages of having your account managed.
The issues that have hung over the market for the past several months are not going away. It is likely that the debt ceiling will be raised before the August 2nd deadline, but Americans will still be spending more than they are taking in. Europe will probably arrange to keep Greece afloat for several more months, but ultimately its lenders will not be paid back in full. From time to time these and other issues are going to flare up, and stocks will be affected. The best thing we can do as investors is realize that if policymakers are not willing to pursue constructive, long term solutions then stocks are going to remain stuck in a range. Therefore we cannot succeed by chasing strength. On the other hand, rather than fearing market weakness, we should be using it to our advantage.
Commentary – Know Your Losses
No matter how good an investor is, he or she is going to lose money from time to time. Sometimes you over-estimate the potential of a fund or a stock, sometimes the market just takes everything down with it. Investors typically cope with the prospect of losses in one of two ways – either try to avoid losses altogether, or try to make sure all losses are small ones. Loss avoidance is psychologically preferable. The problem is that loss avoidance strategies usually don’t pay very much. We have had periods of time where investing in guaranteed bonds or certificates of deposit paid handsomely, but today yields on these type of securities pay next to nothing. For the investor who wants to earn a return greater than inflation on an after-tax basis, you have to risk principal. To be successful, you have to understand the nature of the potential losses you face.
Markets fluctuate. If you cannot grasp and be comfortable with that fact, you aren’t an investor – you’re a saver. Investors know that it is precisely the fluctuating nature of market prices (be they stocks, bonds, gold, or pork bellies) that provide the opportunity for profit. So when you are contemplating a purchase, you should ask yourself two questions; “How much might I lose?”, and “How long would it take to recover that loss?”
There are three categories of losses. The first and most common is the transitory or short-term loss. Typically, investor perception has taken a mild turn for the worse. If the investment was based upon a solid foundation (the promise and ability of the issuer to repay the bond with interest, or the profit growth of the company, for example) the loss should be small and the price should recover in the fairly short term. Savvy investors welcome these occasions as buying opportunities. The second category is significant impairment. This is a situation where the loss is sizable and the while the prospects for an eventual recovery are good, it will take a very long time. Impairments tend to occur either when a solid company turns out to be not-so-solid, or when an investment is made where a solid foundation does not exist and the investment (speculation) disappoints. The third form of loss is the permanent destruction of principal. The enterprise (gamble) failed; you have no hope of ever recovering your principal.
The mistake most investors make is to see a significant impairment when they in fact have a short-term loss. They sell a security that would certainly recover on its own. It is one thing to trade for advantage (replace one security with a similar one expected to perform better), but if you sell for cash you are taking a loss. It could be a good move if you recognize a more serious loss in the making, but all too often it is an emotional reaction that winds up costing the investor. The second most common mistake is to fail to see the possibility of an impairment or permanent loss. This occurs when an investor is so enamored with the potential of an investment that they do not see the risks. The mania for investing in internet stocks in the late 1990s and real estate in the last decade was predicated on the notion that you could make a lot of money in a relatively short period of time, and that the risk of loss was very small. There is no (legal) investment that has ever fit that description. A lottery ticket can be described as a small risk in search of a large payoff, but the risk of a complete loss is, of course, quite high. [This mistake also applies to collectibles. If you buy silver or art or coins or dolls or baseball cards or first edition books, for example, you are speculating. You assume the supply is fixed and the demand will grow, such that rising demand will push up the price. However none of those collectables can do anything in and of itself to increase its value. Beanie babies don’t have their own babies; a gold bar does not grow. It is never going to be in better condition than when you bought it; in fact it might have deteriorated]. I mention this because I believe precious metals are being thought of today the way real estate used to be thought of. Those who bought gold in 1979 or 1980 had to wait close to 25 years to break even.
This should give you an insight into why we invest the way we do. We know we are going to suffer losses from time to time, but we want to make them small ones. First, we prefer mutual funds and ETFs to individual stocks and bonds because it is a lot easier to suffer a significant or permanent loss in a particular company than on a whole industry or country. Even the worst diversified losses (85% in the U.S. in the Depression and more than 50% on several occasions thereafter) have been recovered in time, whereas stocks like Pets.com and ADC Telecom never did. We prefer stock and bond funds to other types of investments because they generate cash flow that we can value. We don’t have to guess at future demand – only at what price level the income or earnings will trade at. Second, we try to be careful not to own too much in areas that have already had a strong run up in price. Technology stocks still trade quite a bit lower than they did in 1999 not because we use less technology but because our growth assumptions back then were wildly unrealistic. We’d rather be conservative and then be surprised on the upside than be too optimistic and be disappointed.
To sum it up, then, not all risk is the same and – if one is truly an investor – not all risk should be avoided. We invest in ways that seek to reduce the chances of a principal loss that cannot be recovered reasonably quickly through the normal functioning of the financial system.
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Past Performance is no assurance of future results
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[i] Standard & Poors, per J.P. Morgan Asset Management
[iv] MSCI EAFE Net Return, US Dollars, per Morningstar
[v] MSCI Europe Net Return, US Dollars, per Morningstar
[viii] Barclays Municipal Bond Index per Morningstar
[ix] Barclays High Yield Corporate Bond Index per Morningstar