2010 First Quarter Market Update
Submitted by skidadmin on Thu, 04/15/2010 - 00:00
The early part of the first quarter looked like it might be the beginnings of the long anticipated correction to the great bull run that began in early March, 2009. The market traded off more than 8% from mid-January to early February. Much of this was related to the strengthening dollar as a result of developing sovereign credit concerns in Greece, Spain, Portugal, Italy and Ireland. As it has with every other crisis that has popped up in the past year, the market eventually shrugged off the sovereign credit crisis and resumed its rally. While the market is up 75% since the March 2009 lows, we still have several reasons to remain optimistic about the equity market in the near-term: 1) low short-term interest rates, and a public commitment from the Federal Reserve to keep them low for an “extended period”; 2) an improving, albeit slowly, domestic economy; 3) steadily improving corporate earnings; and, 4) a significant under weighting of equity securities in institutional and individual portfolios. We doubt that the market can experience a meaningful market correction while seemingly everyone is waiting for it to happen.
The domestic stock market, as measured by the S&P 500, was up another 5.4% in the first quarter. Domestic small-cap stocks, as measured by the Russell 2000 Index, fared even better with an 8.9% return for the quarter. International stocks, due to the strength in the dollar, didn’t perform nearly as well as the domestic market. Developed country stocks were up 1.3% and emerging market stocks were up 1.5%. As a result of the weaker performance of overseas markets, the Morgan Stanley All-Country World Stock Index was up 3.2% for the quarter. Each of the less risky asset classes we’ve been utilizing outperformed the global equity market and many outperformed the S&P 500. Our preferred stock funds returned 8.6% for the quarter; our convertible and high yield bond funds returned 5.1%; and, our senior bank loan funds returned 13.4% for the first quarter. In addition, we continued to find value in real assets. Energy infrastructure companies, as measured by the Alerian MLP Index, returned 8.3% for the quarter. The bond markets were considerably less exciting in the first quarter. Taxable bonds returned 1.7% for the quarter and intermediate tax-exempt bonds returned 0.7%. Lower quality taxable and tax-exempt bonds continued to outperform their investment grade brethren.
Our asset allocation process begins with an independent, unbiased ranking of numerous asset classes based on expected returns, historic volatility and the interaction, or covariance, of each asset class with the other asset classes. One of the things we track closely, in an effort to validate, or not, our asset class rankings, is the Investment Company Institute’s weekly mutual fund flows report. In late 2008 we started pounding the table that bonds were extremely undervalued relative to stocks. They had fallen as much, and in some cases more, than stocks in the months following Lehman’s bankruptcy—that didn’t make intuitive sense to us. High yield corporate bonds, as a group, were yielding over 24% in December 2008—today they are yielding 8.3%. Some of the change in yield can be explained by an improving economic environment and the fact the asset class was grossly oversold in December 2008; but, we suspect a lot of the change can be explained by mutual fund flows. Over the past 12 months equity mutual funds have seen a net inflow of $24 billion, whereas bond funds have seen a whopping inflow of $396 billion. The more money that flows in to bond funds, the higher bonds prices (which means lower yields) will go. Currently, the yield premium (the amount of additional yield over comparable maturity U.S. Treasuries) that lower quality bond investors are demanding is back to the levels the yield premium was in late 2007—before the credit crisis began. The stock market would have to rally another 25% to get back to those pre-crisis levels. While we still favor corporate debt over U.S. Treasuries, agencies and mortgage-backed securities in our taxable fixed income holdings, we believe the risk/reward characteristics of the taxable bond market as a whole have eroded meaningfully due to the massive flow of funds into the asset class over the past twelve months. Bonds may continue to perform well, but if they do we are quite confident stocks will perform even better.
The above is a very specific example of a theme we’ve been advocating for some time now: the importance of utilizing a dynamic asset allocation process in order to capture returns over the next several years. The Great Moderation, that period which began in the mid-1990s in which many economists and policymakers believed they had finally hit upon the exact recipe to smooth out, if not eliminate, the traditional business cycle, was a myth that was ingloriously debunked by the Great Recession. We believe we have entered a period, similar to the 70s, in which the economy and markets will move in more “boom and bust” cycles. A dynamic asset allocation strategy that is focused on achieving clients’ absolute return goals with the least risky portfolio possible will be best positioned to succeed in such a volatile environment.
All of this was a long way of saying that we remain optimistic about the equity markets. The first leg of this rally was short-covering that created a floor for prices and started to push them higher. The second leg was driven by early believers in the recovery and disciplined long-term investors taking advantage of historically low valuations. The third leg will be the return of the individual and institutional investors who have remained on the sidelines. At present we are overweight domestic equities and emerging markets and underweight developed international markets. Within domestic equities we have a modest overweight in small- and mid-cap stocks versus large-cap stocks. Our fixed income portfolios remain relatively short. While we don’t expect the Fed to increase short-term interest rates any time soon, we do expect longer term rates to continue to rise due to an overcrowded Treasury issuance calendar. We continue to like real assets due to their current high correlation with emerging markets and their longer-term inflation hedge attributes. We still favor senior bank loans and certain convertible and preferred closed-end funds that remain priced at 10-15% discounts to their underlying net asset values. As always, we will continuously monitor the investment landscape for the optimal risk/return attributes necessary to meet your investment objectives.
Jim Robinson CEO & CIO—Telemus Capital Partners
Disclaimer and Disclosures
This report is provided for informational purposes only, and does not constitute any offer or solicitation to buy or sell any security discussed herein. All opinions expressed and data provided herein are subject to change without notice. All investments involve different degrees of risk. You should be aware of your risk tolerance level and financial situations at all times. Past performance does not guarantee future results.
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