Q3 2012 Market Commentary
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By Matthew T. Skaves, CFA
Since the recession ended, the U.S. stock market has rallied significantly. Though it has experienced some dips along the way, the S&P 500 Index, the most common indicator of U.S. stock market performance, has doubled in value since reaching a bottom in March 2009. Stock market volatility, as measured by the CBOE Market Volatility Index (VIX), sits near a five-year low (see chart below).
Given this good news, you might be surprised to read, then, that we’re still enduring one of the most difficult investing environments in recent history. Even though the stock market is up, the U.S. economy hasn’t quite followed suit. Because of this, and because we’re still grappling with the fallout from the extraordinary measures taken to contain the 2008 financial crisis, things are quite mixed up at the moment. Here are the primary issues giving us pause:
- Real yields on Treasuries are negative going out almost 20 years, and spreads on investment grade corporate bonds have compressed such that there’s little risk premium being paid to hold corporate versus government debt. Because high quality bonds have become so unattractive, investors have been forced into riskier asset classes like stocks and junk bonds.
- With a trailing Price to Earnings Ratio (PE) of 16.5, the S&P 500 Index looks approximately fairly valued relative to its long-term historic average PE of 15.5. Its Cyclically Adjusted PE Ratio, which adjusts for the impact of inflation on earnings, sits at 22.8 versus its long-term historic average of 16.4. This means that stocks are no longer cheap just at a time when investors are being driven into them because of low interest rates. The current bull market is now 39 months old, just shy of the 44 month average.
- Chinese stimulus in response to the 2008 crisis helped pull the global economy out of recession by lifting the prices of iron ore, oil, and other commodities. But China may not have the political willpower or the financial resources necessary to save the world again if needed. Expected Chinese GDP growth has been revised downward in the 7-8% range, and the HSBC China Purchasing Managers’ Index ended September at 47.9. This is the second month in a row that the index ended in contraction territory.
- Europe’s sovereign debt crisis highlights just how overextended governments and central banks around the world have become. It also underscores the potential for social unrest in the Western world. Furthermore, economies across Europe have either stalled or are beginning to stall, which will likely have some impact on the U.S economy. The German Ifo Business Climate Index ended at 93.2 in September, its lowest level since May 2009. The Markit Eurozone Manufacturing Purchasing Managers’ Index ended at 46.1, its 14th month in contraction territory.
- In the U.S., we are left with increasingly less potent and less popular monetary policy options. The Fed tried to go big, or as big as it could, with its latest round of quantitative easing, offering no specific end date or fixed purchase amount. But with interest rates having already been this low for this long, it’s unlikely the Fed’s action will have a meaningful impact on spending or unemployment. The Fed has very few tools left to boost the economy should conditions worsen, and there is always the risk that the inflation genie escapes the bottle.
- In the absence of effective monetary policy, one might hope for sane fiscal policy to spur employment and boost economic growth. But there is no political consensus on fiscal policy. Instead, the American people have been treated to round after round of brinkmanship, the latest coming in the form of the “fiscal cliff”. Although some band-aid will certainly be pushed through at the eleventh hour, it’s unlikely to have any long-term benefit. One must question whether our fractured political system has the ability to generate the type of grand bargain necessary to quell deficits and spur sustainable GDP growth.
This list is not meant to scare, but rather to illustrate the issues that we believe have the potential to most impact portfolios today. The investing environment was turned upside down in 2008, and it remains just as non-traditional now. We’ve therefore had to be a bit non-traditional in our approach, in order to capitalize on certain opportunities and protect against particular threats.
Up until the recent quarter, we were a bit overweight on risk assets, such as stocks and high yield bonds. This proved mostly beneficial, as risk taking has been rewarded. High yield bonds, for example, have not only provided outsized income during a period of historically low interest rates, they have also risen in value.
But now, after a nearly four-year climb in the value of risk assets, bargains are becoming harder and harder to come by. For this reason and the others mentioned above, we have decided to scale back risk in client portfolios. In the third quarter:
- We reduced equity allocations, especially for our most risk sensitive clients, in favor of hedged equity investments. These hedged investments will still go up if the market continues to rise, just not as much. At the same time, they will not fall as far if the market drops.
- We reduced exposure to high yield and other credit-sensitive bonds in favor of investment-grade bonds. Yes, investment-grade bond yields are unattractive, but these bonds still offer a degree of portfolio stability that cannot be matched elsewhere. We have not eliminated our high yield bonds. They still have a role to play, but we have pared them back.
- We reduced commodity exposure because commodities are volatile investments that imperfectly track inflation in the short term. With growth in China slowing, and with growth stagnant elsewhere, there appears to be less upward pressure on commodity prices for the time being. That said, we recognize governments have an incentive to inflate their debts away, and we maintain core commodity holdings to protect against this threat.
As a matter of discipline, we typically don’t make large shifts in allocation all at once. There are many nuances to consider when managing assets for individuals, such as each individual’s time horizon, risk tolerance, and tax sensitivity. That said, this was one of the larger changes we’ve made in some time. We believe the macro environment necessitates such change, but only time will tell if we are correct in our thesis. If the economy significantly improves and markets move higher, then we will have left some gains, certainly not all, on the table. However, if volatility flares back up or valuations peak, then clients will have been better protected for our actions. During mixed up times like these, we prefer to err on the side of caution.
When next we write, it will be the New Year! Until then, each of us at Deighan Wealth Advisors wishes you a healthy and happy holiday season. As always, we welcome any comments or questions you might have.