Q1 2013 Market Commentary

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Market Commentary
By Matthew T. Skaves, CFA

U.S. Markets Hit New Highs

Unless you’ve been living under a rock for the past few months, you’ve likely read countless headlines detailing the rise of the Dow Jones Industrial Average and the S&P 500 Index. Both are broad measures of U.S. stock market performance, and now, after five and a half long years, these two indices have finally recaptured highs last seen in 2007.

This is exciting news, and there’s been plenty of euphoria going around. Analysts have been raising earnings estimates, stock funds have been seeing inflows, and clients have been asking for more stock exposure. Everyone, ourselves included, has been enjoying the ride.

Our Role as Disciplinarians

Still, although we like a good rally as much as anyone, it’s our job to bring discipline to the investing process. This is one of the most important things we offer clients, because discipline is something capital markets and investors often lack.

In 2008 and early 2009, we spent a great deal of time holding our clients’ feet to the fire, keeping their portfolios invested while markets became irrationally oversold. Now, we increasingly find ourselves in the opposite, though equally uncomfortable, position of moderating our clients’ exposure to U.S. stocks while they continue to advance.

Why would we do this? Why would we trim stocks just as they’re rising? Why might we invest in non-U.S. stocks, or hard assets, or bonds when U.S. stocks have been the clear, recent winner? We have at least a couple responses to these questions.

One is that the future is uncertain, and therefore we must build portfolios that can benefit from, or withstand, a variety of outcomes both positive and negative. We do this by diversifying across sectors, countries, and asset classes. Markets can turn quickly, and having a sound, strategic asset allocation is the best defense against market unruliness.

Another is that a bird in the hand is worth two in the bush. This is a tired truism, for sure, but it’s nevertheless relevant. When markets rise, we’re happy to bank gains for our clients and move them into either safer assets or assets that offer better relative value. To assume that an investment will continue to rise simply because it has risen in the past is to look only in the rearview mirror. To stretch your discipline merely for the potential of future gain, all while risking a known gain, is tantamount to shaking the bush with both hands while holding your bird by your teeth.

There are times when being disciplined isn’t in vogue, and this is one of those times. Yet, discipline is often needed the most when markets are moving strongly in one direction or another.

What, Me Worry?

For the better part of four years, the U.S. stock market has climbed a “wall of worry.” In other words, stocks have risen, though reluctantly at times. Fears about the economy, Europe, the Fiscal Cliff, and so forth, have caused dips along the way.

Recently, however, U.S. stocks have been doing a lot of climbing but not a lot of worrying. The CBOE S&P 500 Volatility Index (VIX) has been sitting around 5-year lows since the beginning of the year. Meanwhile, the Dow Jones and the S&P 500 have risen almost linearly. The last time the VIX was this low was January 2007, near the peak of the last bull market.

It seems the U.S. stock market has gotten complacent. Take the Cyprus incident, for example. Investors have understandably become numb to the situation in Europe, which has dragged on for three years now. But the situation in Cyprus barely registered a blip in U.S. markets. Granted, Cyprus is a country with a population smaller than the State of Maine. Yet the precedent set there, that the government can hypothecate depositor assets to bail out banks and politicians, is a dangerous one. There’s a reason why Cyprus closed its banks for days and then only partially reopened them with low withdrawal limits. It’s because the depositor haircut had, and still has, the potential to trigger bank runs. Depositors in Italy and Spain must be questioning whether or not it makes sense to keep large balances in their national banks, given the precedent set in Cyprus. Meanwhile, U.S. stocks are not accounting for Europe in any meaningful way.

So, why are U.S. stocks ignoring Europe and other economic or geopolitical risks? Well, on the one hand, there have been genuine improvements in the U.S. economy. Housing has bottomed and begun to rebound. Unemployment has dropped to a four-year low. Consumer sentiment is up. The country is working toward energy independence, and so forth. These are all good things, and they warrant a healthy stock market.

But more importantly, the Federal Reserve is distorting capital markets with its continued, massive quantitative easing. For weeks, politicians stoked fears about the $85 billion sequester and its potential impact on the economy. To put this into perspective, the Fed is injecting $85 billion of stimulus into capital markets every month via its purchase of Treasuries and mortgage-backed securities. Such stimulus has artificially kept interest rates low, spurring the economy.

However, what it’s also done is make it impossible for investors to earn a return on investment without taking inappropriate risks. Therefore, investors large and small have increased their allocations to riskier asset classes, like stocks, to meet their return goals. In other words, the Fed’s monetary stimulus has been a major tailwind for U.S. stocks. In the absence of this tailwind, stocks would be lower today. Quantitative easing has acted as a backstop for U.S. stock markets, dampening volatility and allowing for, even rewarding, the complacency we’re witnessing now.

Not Fed Up Yet

At some point the Fed will need to end, or even reverse, its easy money policy, at which time stocks should correct and interest rates should start to rise. The hope is that that the Fed gets its timing right and applies the brakes only once the economy is healthy enough to absorb the higher capital costs that come with higher interest rates. The Fed has stated that quantitative easing will continue until unemployment is below 6.5%, so long as inflation does not exceed 2.5%. If history is any indication, however, the Fed will do a poor job of timing its exit strategy. After all, it was easy money in the 2000’s that led to the housing bubble and poor Fed timing that caused it to pop.

With no specific end date to go by, investors have been left to fend for themselves in determining when interest rates might rise. For our part, we’ve been both opportunistic and proactive. After taking advantage of very successful high yield and convertible bond markets in 2012, which allowed us to outperform while still keeping portfolios relatively short-term, we’ve sold most of these assets. The bulk of our credit exposure in fixed income portfolios now resides in senior floating rate loans, which stand to fare better in a rising rate environment, and international bonds, which are less impacted by the Fed’s policies. The average duration of client bond portfolios is less than three years, again a precaution against rising rates.
An American Phenomenon

Despite rising stock prices, and despite market complacency, investors don’t necessarily have it easy today. Bonds return very little, and U.S. stock markets, by some measures, are fairly valued. This means investors must be discriminating when deciding where to park their money. Over the past five years, U.S. stocks, as measured by the S&P 500 Index, have risen a cumulative 26.8%. Foreign developed nation stocks, on the other hand, have declined a cumulative 7.2% over that time, as measured by the MSCI EAFE Index. Emerging market stocks have been flat at a cumulative 1.05% over five years.

This means U.S. stock returns have been a bit of a phenomenon. Over the long term, we don’t view this sort of outperformance as being sustainable. Therefore, we continue to find foreign stocks attractive, especially relative to high-flying U.S. stocks. To that end, we’ve maintained our foreign stock allocations and in some instances increased them. At a time when American markets are expensive, foreign markets offer better long-term value.

Have a Wonderful Spring

Old Man Winter hasn’t given up quite yet, but the days are longer and spring is right around the corner. Soon we’ll all be in our gardens and flower beds, clearing out the dead leaves, laying down mulch, and planting things for the future. It’s this sort of discipline we bring to bear on portfolios. Like gardening, investing can be a muddy process. But when done with thought and care, both can be rewarding.

We appreciate the confidence you place in us. From everyone here at Deighan Wealth Advisors, we wish you a happy spring!