3Q12 Quarterly Perspective

Summary

Stocks continued their rally in the third quarter.  The adage, “Sell in May and Go Away” has gained favor in recent years, in spite of the fact that the past two years have seen a very nice summer rally.  In 2013 it was driven by a surprise improvement in the European economy and a general sense that the global economic recovery, though disappointing by past standards, is for real.  The market is finally being led by economically sensitive sectors like industrials and consumer discretionary (think autos and washing machines).  Previously (2009-10) it was led by interest rate-sensitive sectors like housing and financial services (because the Federal Reserve was driving down interest rates to stimulate the housing sector) and defensive sectors (utilities, health care and consumer staples^[1]) because investors preferred current income to future earnings growth.  That income-oriented securities are out of favor now is a telling sign of confidence in the global economy.

 

It should come as no surprise, therefore, that foreign stocks performed better than domestic stocks last quarter.  Foreign stocks were priced for recession, so there was more room to run when their outlook improved.  There are two benefits to a positive foreign economic surprise – the stock AND the currency rise together.  Foreign stocks rose 7.5% (versus 5.2% for the U.S.^[2]) in local currency terms, and because the Euro had a very strong quarter, that gain rose to 11.6%^[3] for U.S.  dollar-based investors.  This, my friends, is why you diversify.  You don’t know exactly when the benefits of diversification are going to kick in (they’d been largely absent in recent years) but it is sure nice when they do.  Small company stocks performed significantly better than larger companies (10.2% to 5.2%^[4]), further evidence of the power of diversification.

 

Figure 1

 

Source: JP Morgan 4Q2013 Guide to the Markets

 

One diversifier that certainly did not help last quarter was real estate.  This sector fell -3.3%^[5] last quarter as investors continued to shun interest sensitive sectors.

 

Bonds leveled off last quarter after a terrible second quarter.  The Barclays Government/Credit Composite was up 0.4%^[6].   Interest rates are off their July highs as the Federal Reserve sought to reassure bond investors that their tapering would be gradual at best.  Investors have finally embraced the fact that the risk reward trade-off in bonds is not favorable.  The pendulum is swinging back toward stocks after more than four years where bonds had net inflows and stocks net outflows.  Again, more reason as to why Trademark runs balanced, well diversified, portfolios.

 

Activity

International stocks and small cap stocks led the way this quarter, so the key was making sure we weren’t underweight in either category.  Often that meant replacing conservative funds that tread lightly in those areas with ones that will more fully participate on the upside.  We added index funds to many portfolios last quarter, replacing very conservative small cap funds like Aston Independent Value and global funds like First Eagle.   (We will not hesitate to use those two funds again if market conditions warrant.)  On the bond side we lowered interest rate risk by replacing funds like Payden GNMA with shorter duration alternatives such as Met West Intermediate Bond.  We also modestly reduced the cash weighting in most portfolios.

 

Outlook

Stocks have been doing very well lately.  Even the U.S. government shutdown fiasco did not derail the rally for very long, and with its “resolution” we are back to all-time highs in the stock market.  This is not hard to understand in that bonds have done poorly this year and many investors feel they have missed out on the post-2008 equity recovery.  With the Federal Reserve seemingly afraid to reduce their liquidity providing efforts by even a tiny amount, it seems as though stocks have nowhere to go but up^[7].  It should be recognized, however, that at the very least stocks are ahead of economic fundamentals.  It is worth noting that although the economy and stocks have been advancing higher since 2009, stocks are now outpacing economic growth as measured by Real (after inflation) Gross Domestic Product.  See Figure 2.

 

Figure 2

 

Retrieved from: : www.seekingalpha.com, Stocks and QE: All Things Must Pass

 

While it can be argued that the stock market leading the economy is the normal state of affairs, the degree to which this is the case is unusually large at the present time.  Market “corrections” happen when investors begin to fear that earnings won’t live up to projections.  Stocks certainly have a head of steam right now, but my concern is that gains from here will only make the eventual correction more painful.

 

Bond yields have stabilized at higher levels.  A new Fed Chairman (Janet Yellen) has been named.  It is unlikely any policy change will take place at least until she officially takes over for Bernanke in January.

 

Commentary – Life on the Savannah (The Wise Zebra)

I sometimes think investing is like being in a herd of zebras.  In the middle of the herd there isn’t much grass, it having either been eaten or trampled.  Around the outside of the herd, where only the bravest zebras venture, the grass is thick and plentiful.  Unfortunately, there are also lions.  Lions are stealthy; you know they are out there, but you usually don’t actually see them until it is too late.  If you stay in the middle of the herd you are safe from lions, but you will eventually become lean and sickly from lack of nourishment.  In this case you have to worry about cheetahs (smaller predators that can only take down weaker zebras) or, at some point, starvation.  So as a zebra, there is always risk of one kind or another.  To thrive, you must develop a sense of when to venture into the thicker grass and when not to.  Investors are similar to zebras in that they also have to take some risk if they want to prosper, but too much risk or ill-timed risk can be dangerous.

 

Every savannah is different.  In 2009 we encountered a situation where surviving zebras found grass everywhere.  The lions were exceedingly well-fed and were therefore nowhere to be found.  Even in the middle of the herd there was some grass, so being cautious didn’t hurt.  As time wore on, however, there was less and less grass for those who wanted to play it safe.  By 2013, the savannah we call the capital market was well trampled.  Those who stayed in the center (money markets) starved.  In May cheetahs came in the form of rising interest rates.  Healthy zebras (those investors that had stocks in their portfolios) had little to fear.   Under-nourished zebras (those that only owned bonds) ultimately became cheetah food.

 

Behavioral science has shown that humans tend to fear things that best approximate our most recent source of trauma more than things that present a higher probability of future danger.  This phenomenon has a name: recency bias.  Because portfolios were cut down by economic risk in 2008, many investors sought to minimize economic risk exposure.  Thus, they sold stocks and bought bonds in record numbers between late 2008 and early 2013 (See Figure 3).  However, this is not the risk that presented itself in 2013.  Investor intuition regarding their biggest source of risk turned out to be completely wrong!

 

Figure 3

 

Source: JP Morgan 4Q2013 Guide to the Markets

 

This is not to argue that one shouldn’t worry about the economy or that stocks are less risky than bonds going forward.  I’m arguing that following the herd does not necessarily keep you safe.  The investing herd often reacts in a panicky fashion to current trends, while having poor foresight with regard to future risks.  The wise zebra, on the other hand, understands the nature of life on the savannah.  He knows that from time to time predators attack.  He knows he has to be healthy to survive the cheetahs, but if he is reckless he will fall prey to lions.  A handful of zebras venturing into the tall grass might not attract lions, but a whole herd of risk taking zebras almost certainly will.  The year-to-date return on stocks is 20.4% as I write this, while the year-to-date return on bonds is -2.1%^[8].  It isn’t hard to imagine what the herd has been doing lately.    Money is now pouring out of bonds and into stocks. The wise zebra was in the tall grass months if not years ago.  Today he is starting to look out for lions.

 

Remember, we update our blog periodically with my latest thoughts on the market.  (www.trademarkfinancial.us/blog)  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.

 

We appreciate your continued trust in our management program,

Mark A. Carlton, CFA

 

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