Quarterly Perspective for 4Q12

Summary

Asset prices improved in the 4^th quarter for the most part, but the list of winners and losers changed quite a bit from earlier in the year.  As risk appetites grew and fears about a European collapse waned, investors gravitated to smaller companies and international ones.  The Federal Reserve made more explicit its desire to help the economy by making risk assets such as stocks and real estate more attractive[1].   Their theory being that a richer populace is a more economically active one.  One can debate whether these moves will create unintended consequences in the long run that will more than offset the short term benefits, but in the here and now they are creating a favorable environment for risk taking.

The bellwether S&P 500 stock index actually declined 0.4%[2] last quarter, reducing its full year return to 16%.  The chief culprit was Apple Inc., the world’s most valuable company.  Apple gained 32.7% in 2012, but lost 19.8% in the last three months.  The broadest measure of the U.S. stock market showed a 0.3%[3] fourth quarter gain.  Mid and small cap U.S. stocks gained 3.6% and 2.2% respectively.  Financial Services was the leading industry last quarter as investors gained comfort that the world’s central banks had effectively re-liquefied the industry such that no defaults were imminent.  Utilities, the sector investors tend to go to for safety, posted a modest decline.  Safety is not presently in fashion.

 

S&P 500 Return for 4Q12 and 2012

Source: 1Q13 JP Morgan Guide to the Markets.  All calculations are cumulative total return including dividends reinvested for the stated period.

 

One of the ways investors obtained higher returns last quarter was in foreign stocks.  A resurgent Euro coupled with a decline in risk perception led to a strong quarter for European stocks (7.0%)[4].  Emerging markets rose 5.6% and even Japan joined the rally (5.8%).  The latter benefited from the belief the Japan’s new Prime Minister could at long last get his economy stimulated by pursuing more inflationary policies.  Such is the state of the global economy that the market cheers inflation.

Bonds usually don’t do too well as a whole when economic growth is accelerating, and last quarter was no exception.  The Barclays Aggregate gained 0.2% on the quarter, lifting the full year bond return to 4.2%[5].  Bond investors did much better in those bonds that have some equity-like properties, as those do much better in a “risk-on” environment.  High yield corporate bonds and emerging market debt each gained over 3% last quarter and more than 15% in 2012.  They are both profiting from investors’ frantic search for yield.  One should remember that with higher yields also comes the loss of diversification benefits.  In other words, in a falling stock market those types of bonds will probably behave like stocks.

 

Activity

 

We continued to increase the foreign stock exposure in our portfolios.  Global growth is generally associated with a falling dollar, while world economic crises tend to cause the dollar to rise.  Emerging markets seem the most likely to gain from superior economic growth and currency appreciation, so that is where new purchases were targeted.  We did not change the bond component of our portfolios much.  The Fed’s policies are generally bond favorable (at least in the short term), but the valuations of most bonds are not attractive.

 

Outlook

 

We continue to feel that stock prices have done better than their underlying earnings warrant.  No doubt a great deal of this is due to Federal Reserve policy – if you want to make more than around 3% per year right now you have to take equity-type risk .  The climate of fear that pervaded the market in the wake of the 2008 market debacle enabled investors to buy stocks and riskier bonds at what proved to be a discount, since the risk of another market collapse was over-priced.  That is no longer the case.  In other words, there are still apples on the tree, but the ones on the easy to reach lower branches have all been picked.

That said, I believe the wind is still at our backs.  Market liquidity is very high.  I can’t see a meaningful decline as long as world central banks are this accommodative.  While I’m sympathetic to concerns that this easy money policy ultimately will produce a devastating crash somewhere, I do not see that time being in the first quarter of 2013.

 

Commentary – Risk Management

 

The stock market[6] has been rising for most of the past four years and is nearing the levels it reached at the previous market peak in 2007. However, as the chart below shows, if dividends were re-invested the market is up 2.3% since 2007.  Investors could be forgiven for not realizing how far we’ve come, given that all we hear about today is the soaring national debt, the debt ceiling debate, and the mess in Europe.  So what should we make of this?  Should we be looking to sell, or can this rally go a lot further.  This is a critical question because it is not enough to know that there will at some point be a day of reckoning; it is critical that you get the timing approximately right.  To get out too early is to be wrong, for you may miss more on the upside that you would have lost later on the down side.   So, how do we invest to earn as much as possible within our risk tolerance, yet not be over exposed when the inevitable comes to pass?

 

 

Source: 1Q13 JP Morgan Guide to the Markets.  All calculations are cumulative total return including dividends reinvested for the stated period.

 

First of all, there is always something to fear – inflation, recession, political crisis, etc. – such that to move to the sideline whenever you perceive risk is to not to be an investor at all.  On any given day, the top of the market may be years and dozens of percentage points away.  The markets will eat your lunch if you can only stomach the best of times, because you will sell into fear (low) and buy into greed (high).  Too often I have seen investors ruled by their emotions, with less than stellar results.  The typical emotion-based investing pattern goes like this:  right after a market crisis investors are nervous.   They therefore over-estimate risk and as such are under-weight risky assets like stocks.  They are suspicious of the market recovery when it comes, and with every minor market retreat they think “here we go again.”  They under-perform the rallies, but initially they are happy just to be making money again.  Because the occasional pullbacks are continually modest, they stop being a source of terror.  As the markets’ advance continues, investors begin to get more aggressive.   As the advance matures, aggressive areas of the market crowd out conservative ones, because that is where the performance is.  Fear has given way to greed.  Eventually, of course, the next crisis hits, the market falls and investor portfolios (now aggressively positioned) are significantly impacted.  They try to preserve their remaining assets by getting more conservative, starting the cycle over again.

In many cases, investors’ poor performance didn’t result so much from whether they traded or how often they traded but instead on when and what kind of trades they made.  So what constitutes a good trade versus a bad trade?  If we sell a rising asset and it turns out that it was “too early” (the asset continues to appreciate) did we make a bad decision?  Not necessarily.  It depends on the reason for the sale.  A good sale is one that reduces your LONG TERM[7] potential loss more than it reduces your LONG TERM potential gain.  A good buy, it follows, is one that increases your long term potential gain more than it increases your risk.

From time to time we have taken defensive measures in our portfolios because we felt the risk of loss was high relative to the potential for future appreciation.   There are better and worse times to get defensive, just as property insurance may vary dramatically in price based on the insurance company’s assessment of its risk.  If there is a devastating hurricane, for example, insurance companies may experience very large losses.  They will raise their rates for two reasons – they need to replenish their reserves from the past loss and they know demand for insurance will be higher[8].   The insurance company doesn’t wish for there to be no storms (for if there were no storms nobody would buy insurance).  They just hope that they have collected sufficient premiums to cover the claims of the next storm (and make a nice profit, of course).

In a similar vein, the smart investor doesn’t wish that the market would never decline, only that they not be over exposed.  Successful long term investors try to protect against large losses, because trying to protect against all losses is so expensive it wipes out almost all return.  Defensive measure we have used in the past include a higher cash position, an exchange to a less volatile fund, taking short position as a hedge, or perhaps a modest gold position.  Employing some or all of these defensive strategies may be warranted if market liquidity is threatened or stock valuations are too high.  These are the two conditions that lead to the vast majority of significant market declines.  That said, most of the scary headlines we read today do not directly affect either of these conditions.  Losses are always possible, but large losses seem unlikely.  Therefore, we believe defensive measures are not called for at this time.

We are always trying to assess whether the return potential in the market is worth the risk at the current price.  If prices go too high or liquidity conditions begin to deteriorate, we may employ some defensive measures – holding extra cash or using lower volatility stock funds, for example.  This helps our clients better resist the normal emotional pulls (the urge to sell after a decline or buy after a big rally) that come with being in the market, because emotion is a wealth killer.  Just as big storms and occasional losses are part and parcel of being an insurance company, market volatility and negative headlines are things you just have to learn to live with if you are going to be a successful investor.

 

Trademark News

Last quarter we told you that we were are developing an iPad, iPhone and Android app.  We hoped it would be ready in December but it was delayed.  With any luck it will be available in the next few months.  We’ll let you know more on our blog (www.trademarkfinancial.us/blog) and in next quarter’s newsletter.  Additionally, we update the blog once or twice a month with my latest thoughts on the market.  If you’d like to be added to the blog update distribution email list or to begin receiving your statement electronically please contact Cynthia Gates at Cynthia@trademarkfinancial.us or 952-358-3395.

 

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