We got off to a bit of a bumpy start in 2014, but we seemed to have stabilized in the last week. Emerging markets have been the focal point of the concerns that have the market under pressure so far this year. There are concerns about liquidity, specifically that investment funds are being withdrawn from the emerging market as investors digest the impact of Federal Reserve tapering. Some of this was predictable. If you consider that the U.S. trade deficit is narrowing significantly due to our boom in domestic energy production, you would realize that the surplus the rest of the world runs with the U.S. is therefore shrinking. Certainly there are fewer U.S. dollars swirling around the Middle East. If an expansion in the U.S. economy does not translate into a widening trade deficit, the world is not getting the dollars they need. (This is especially true for those countries that use dollars to subsidize domestic fuel costs. Their choice is to raise fuel prices – hurting the economy and possibly provoking unrest – or allowing their currency reserves to dwindle and invite more capital flight). Emerging markets are the cheapest they have been since the summer of 2011, but still considerably (85%) above their 2009 lows.
Something to keep in mind – we are seeing many more days where the market gains or loses more than 1%. That is a warning sign. Before a bull market turns into a bear market, volatility always increases. The word market professionals use is distribution, meaning that “smart” money is a net seller of stocks, distributing them to newcomers with the idea of buying them back after the sell-off at lower prices. Markets tend to top out over a period of many months. In 2000, stocks peaked in the first quarter and went sideways with increasing volatility until Labor Day, when the bear market really got going. In 2007 stocks peaked on a broad basis in May, but the market made a nominal new high in October and even into May 2008 looked poised to challenge the 2007 high. Mutual fund strategists are bullish as they always are (that is their job). Portfolio managers are a different story. They are the ones complaining about the lack of attractive opportunities and asking for their funds to be closed to new money.
Real estate has been a pleasant surprise so far this year. The year-to-date gain of more than 7% is ahead of all sectors except precious metals. The recent tepid job reports have really helped income –oriented securities because investors are a lot less concerned about a sharp increase in interest rates. (It was assumed that if the Fed bought fewer bonds, interest rates would certainly go up because by definition supply would be greater. That has not happened). REITs prices are still 10% below their May 2013 highs, so valuations remain reasonable.
I am not as enthusiastic about gold even though it has made a very strong move so far this year. Gold fell a stunning 38% from its 2011 peak to last December. It is up roughly 10% since, and may go up another 10% before stalling out. I’m just wary since gold’s bear market has been so short relative to the bull market that lasted almost ten years. Gold trades at a price it first reached in late 2010; by contrast real estate trades at a level it first reached in early 2006.
It is interesting to me that the best performing sector of the bond market is high yield municipals. Long term bonds have done well (in relative terms) because everybody expected higher rates and shortened maturities. You always have to remember in this business that whenever investors reach a consensus (about anything), THAT CONSENSUS WILL BE WRONG! I like longer maturities because they are under-owned at this point, and I prefer to get them through muni bonds because they were over-sold on the Detroit bankruptcy and Puerto Rico debacles last year. Too many bond investors have focused on interest rate risk these days and not enough are worried about credit risk. Next economic downturn we are going to see a very powerful flight-to-quality.
-Mark Carlton, CFA
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