Stock prices surged in the first quarter of 2013, much as they did in the first quarter of 2012. The similarities end there, however. The stocks that led in early 2012 were largely those that would benefit from an expanding economy – technology, retailing, homebuilding, etc. In 2013, investors favor more defensive industries like health care, consumer staples and utilities. A possible explanation is that investors realize they can’t earn the returns they want in bonds anymore, so they are moving to the most bond-like of stocks. Considering all of the potential pitfalls out there, perhaps they can’t be blamed. After all, just when you think you know all of the risk factors out there, a Cyprus or a North Korea pops up. Happily, those issues have not had a significant impact so far. It appears that with world central banks increasing liquidity at an unprecedented pace, it will take something far more serious to end this bull market.
U.S. Stocks rose 10.9% on the whole last quarter[i]. Large stocks, as measured by the S&P 500 index, rose 10.6%[ii]. Small cap stocks gained 12.4%[iii]. As mentioned, the market was led by the most conservative sectors of the market while the traditional high return sectors lagged. Tech stocks were hurt by the negative 16.3% return from Apple Inc., the largest company in that sector. Materials were impacted by slowing growth in China. Gold stocks fell because the feeling of crisis that pervaded markets for much of the past several years has lessened. The deficit situation has not improved nor has the crisis in Europe been solved, but investors can’t live in a state of fear permanently.
Source: JP Morgan 2Q13 Guide to the Markets
International markets were not nearly as generous to dollar-based investors, as most foreign currencies slumped against the dollar. As a whole, foreign markets rose 5.3% last quarter[iv]. Japan soared 11.8%[v] on Prime Minister Abe’s radical plan to stimulate the Japanese economy, but the countries in the region that compete with Japan (South Korea, Taiwan, and China especially) saw their markets decline. National resources-oriented economies like Russia and Brazil also declined. Europe was up 2.9%[vi], as European stocks were able to gain mildly from the decline in the Euro.
Bonds lost ground on the quarter (-0.12%)[vii]. Interest rates rose sharply in January on the belief that the economy had turned the corner. Those assumptions have been seriously called into question by quarter end, but bonds did not climb into the black until the first week of April. High yield corporate bonds rose 2.9% to pace the sector, but the second place bond sector, municipal bonds, rose just 0.3%. International bonds and emerging market debt fell 2.1% and 1.5% respectively[viii].
We didn’t make any significant asset allocation decisions this quarter because market conditions remained largely favorable. We did start to implement a modest tactical change. We have increased the percentage of exchange-traded funds (ETFs) in our portfolios. ETFs tend to have much lower annual expense ratios than mutual funds, but there is a small cost to buy and sell ETFs as opposed to the vast majority of the funds we use at TD Ameritrade (which have no transaction fees if they are held for ninety days). ETFs also have the advantage of being easier to use to make quick asset allocation decisions, because they can be bought or sold any time of the market day.
Three months ago we wrote that as long as world central banks remained accommodative, we did not expect to see a meaningful decline. We still feel this way, though we don’t expect stocks to gain anywhere near 10% in the second quarter. Seasonal patterns are not as favorable (May and June are among the weakest months historically). It should be noted that stock prices are now some ten percent or so higher than they were at the start of the year, while corporate profits are only slightly higher. In essence, stocks have become 10% more expensive. In the short run, liquidity is more important than valuation. Investors usually respond immediately to changes in the amount and availability of credit in the system, but they seldom make changes based on valuation alone. There is no hard and fast rule about how expensive is too expensive.
We are in a sweet spot right now. The economy is weak enough that the Federal Reserve is maintaining a very easy credit position. If the economy were stronger, this policy would be seen as inflationary and interest rates would rise. If the economy were much weaker, this policy would be seen as ineffective, and consumers and businesses would likely adopt cash conservation strategies that could lead to recession. At some point, however, things will change. If the excess liquidity is removed (either because it has been too effective or not effective enough), asset prices (especially stocks) may be in for some tough sledding.
Commentary – Avoiding the Elevator
There is an old saying, “the market takes the stairs up and the elevator down”. This alludes to the fact that people tend to become optimistic gradually but they get fearful in a hurry. Having endured the crash of 1987 and the financial crisis of 2008-09, one cannot help but have a healthy respect for how fast and how hard markets can move against you without justification. In 1987 neither the financial system nor the economy was in peril, but the market plunged 22.3% in one day because a new computer-based system designed to protect portfolios instead caused waves of selling. It took several weeks to realize that this did not herald a new Depression. In 2008, financial stocks had a well-deserved sell-off, but other perfectly sound assets sold off as well because with banks fighting for their lives, credit was just not available to potential buyers. Those who were fortunate enough to have money didn’t want to part with it.
We bring this up because today’s markets are very different in comparison to when I started in the investment industry in the 1980s. Economic analysis was so much more important then, because stock prices traded largely on the prospects for profit growth, and bond prices on either interest rates or the prospects of a change in their credit rating. The Federal Reserve was a semi-uninterested bystander. It increased or decreased credit (interest rates) in response to the prospects for inflation. It observed employment rates and asset prices, but did not consider it part of its job to manage them. That idea is completely out the window now. Central banks seem to believe not only that they can but also that they should act to manage asset prices in order to both increase employment and protect the financial sector from its own blunders. Typically, the greater a person’s investment portfolio has grown the more they feel like spending – a phenomenon known as the wealth effect. Such consumption can push up asset prices and have unfortunate unintended consequences. Critics have said that the belief that the Fed is supporting asset prices gives investors a feeling of invincibility that leads to over-investment (asset price “bubbles”). Because these bubbles often deflate with ruinous consequences (think of the real estate market over the last decade), easy credit may ultimately do more harm than good. At the very least, they distort the normal economic signals financial analysts get from measures such as the shape of the yield curve.
I don’t want to make it seem like everything that happens (good or bad) is the Federal Reserve’s fault. Far from it. What I am saying is that because they can (when they choose to) have a large effect on both the bond and the stock markets, and because they are more willing than ever to use that power, financial analysis now has to concern itself like never before with the question of what the Fed is going to do. And this creates perverse behavior – like investors cheering weak economic news because they believe it will bring more Federal Reserve stimulus.
Ordinarily, one would respond to a situation where valuations were high and economic predictability was low by being extra defensive. If interest rates were normal, we’d be very tempted to put 20% of portfolios in cash and earn 4% or so while we see if the Fed’s efforts work and if Europe can keep from imploding. Of course, cash doesn’t yield 4% today – it yields less than 0.1%. So you have to decide to accept lower portfolio returns or take greater risks in order to reap the same level of returns. Many investors have already chosen to take risks they wouldn’t otherwise take if yields were closer to normal. And when you push people into taking more risk than they are comfortable with, they won’t hold on when prices start to fall. On the plus side, bull markets typically don’t end until they have drawn in much more substantial participation from smaller investors. The fact that there is still a lot of fear and skepticism even though (domestic) stock indices have made new all-time highs suggests we still have a little ways to go on the upside. Or so I hope.
Hopefully we have articulated the challenges investors face today and why many professional securities analysts are uncomfortable at this point. We don’t know how the Federal Reserve will ultimately withdraw liquidity and restore a reasonable interest rate to savers without causing considerable turmoil in the financial markets, because such a thing has never been tried before. Having experienced the proverbial elevator ride five years ago, we feel compelled for our investors not to let that happen to them again. If we give up some upside in the process (and let’s be honest, we have) that is a trade-off we believe most of you are willing to make[ix].
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[i] Wilshire 5000 per Morningstar
[ii] Source: Morningstar
[iii] Russell 2000 per Morningstar
[iv] MSCI EAFE ($) per Morningstar
[v] MSCI Japan($) per Morningstar
[vi] MSCI Europe ($) per Morningstar
[vii] Barclay’s Aggregate Bond per Morningstar
[viii] Barclay’s High Yield and Global Aggregate Bond Indices, per Morningstar
[ix] For those that would have preferred to have taken greater risk and captured more upside, we are using more ETFs now to ensure a higher level of market participation.