Market Outlook April, 2012
The first quarter of 2012 has been a prosperous one for equity investors. The S&P500 was up 12.00%, the Dow Industrials (DJIA) up 8.14%, with both small and mid-sized companies slightly outperforming large cap stocks. In our 2012 outlook we stated our belief that “equities should end the year higher than they started, the real action will be in the sectors as well as individual companies.” And for the first quarter we have been correct on direction – although, admittedly, we are a bit surprised by the oversized returns of all the major averages – as well as the selectivity of where positive returns have been generated. Financials, Technology, and Consumer Discretionary have outperformed while Consumer Staples and Utilities have lagged behind.
For the time being, the markets are ignoring what we referred to in January as “irritating factors.” Three months ago the list included European debt issues, U.S. Government debt, a polarized political system, high unemployment, and inflation concerns in the producing countries of Asia. To this list we can add increasing gas prices and political issues surrounding Iran. None of this is new. These issues have been around for some time, and have been cause for concern in the past.
The typical bond investor has not enjoyed the same good fortune as the equity investor with the Aggregate Bond Index up just 0.52% in 2012. Interest rates have continued to stay low, which has helped keep the total return on the index positive, but is of no help in generating more cash flow for the income investor. At some point, we believe this will change.
The prices of small company stocks are generally more volatile than large company stocks. Investments that are concentrated in a specific sector or industry may be subject to a higher degree of market risk than investments that are more diversified.
The first quarter of 2012 has been characterized by low market volatility. The market Volatility Index (VIX) is hovering around 15, a historically low level typically associated with steady, rising markets. History shows us that this type of market environment can be sustained for long periods of time, but the change to more volatility, and lower equity prices tends to be quick and unexpected. Knowing increased market volatility is directly correlated to a poor market environment, we anticipate what factors could produce increased volatility, as follows:
- Global Events – this includes much of what we discussed previously, namely the European debt issue, growing tensions in the Middle East, and the Chinese economy.
- U.S. Political Issues – In the coming months, Congress will be dealing with issues of the ever increasing Federal debt, the Federal budget, and the debt ceiling. The Supreme Court is expected to rule on the Affordable Care Act which, depending on the consensus, could have an effect on companies in the healthcare sector. At the State and Local level it is budget season, with implications for both spending levels and employment. Across the nation, we are gearing up for the November Presidential election.
- Economic Issue – Unemployment and gas prices should continue to be economic issues that stay at the front of the news cycle for the foreseeable future. A spike in either of these numbers has the potential to push down consumer confidence and/or consumer spending.
- Issues Related to Individual Stocks and the Stock Market – This is anything that could have an effect on company earnings that does not fall into the other categories, including, but not limited to commodity pricing, profit margins, bond yields, and market expectations.
Of the aforementioned issues, the least concrete and most subjective area is market expectations. Market and individual company expectations move in predictable cycles due to the backward-looking nature of market forecasting. The typical analyst becomes overly pessimistic around the bottom of an economic cycle and overly optimistic before the peak of an economic cycle. Thus, at the beginning of the cycle a company will often times “beat” expectations with less than stellar earnings and “miss” expectations towards the end of the cycle with very good or even record earnings.
Since the market bottom in March, 2009, we have seen company earnings that have been both stellar and above analyst expectations. Over time, however, the size of the “beats” has become less dramatic as expectations become closer to reality. With earnings season starting in the near future, we will be diligently watching how earnings compare to expectations and adjusting allocations as necessary.
Bond and Income Investing
As we have said for some time now, income investing continues to be a challenge. The days of owning an income portfolio comprised of AAA-rated and insured municipal bonds and AAA-rated U.S. Treasury Bonds or bank issued- CDs to meet income needs is a thing of the past. We are of the opinion that owning a 10-year U.S. Treasury bond is, after incorporating the effects of inflation on buying power, all risk and no yield.
Investing for income strategies, in many ways, is beginning to look like investing in equities. Specifically, we believe investing for income should be diversified between varieties of asset types, will require periodic shifts in the asset classes invested in, and will be more volatile than investors are accustomed to in a bond/income portfolio. Please see our Market Outlook 2012 for more detail.
Investing in fixed income securities involves certain risks such as market risk if sold prior to maturity and credit risk especially if investing in high yield bonds, which have lower ratings and are subject to greater volatility. All fixed income investments may be worth less than original cost upon redemption or maturity.
Bond ratings, issued by private independent rating services, are a grade given to bonds which is designed to indicate the credit quality of the bond. Bonds rated Aaa through Baa3 by Moody’s, and AAA through BBB- by S&P, are typically considered to be investment grade. Investors should note that an investment grade rating does not insure the bond against default and does not guarantee the return of principal.
Stocks offer long-term growth potential, but may fluctuate more and provide less current income than other investments. An investment in the stock market should be made with an understanding of the risks associated with common stocks, including market fluctuations. While stocks generally have a greater potential return than government bonds and treasury bills, they involve a higher degree of risk. Government bonds and treasury bills, unlike stocks, are guaranteed as to payment of principal and interest by the U.S. Government if held to maturity.
The CRB Commodities Index (CRB) is close to flat for 2012, which would normally be a good sign of stable pricing. Delving deeper, however, there have been some very big moves in a number of commodities. Silver and Platinum are up more than 15%, Copper is up 11%, and Natural Gas is down 28% so far. We expect volatility to remain high due to political instabilities and changes in global growth expectations.
Buying commodities allows for a source of diversification for those sophisticated persons who wish to add commodities to their portfolios and who are prepared to assume the risks inherent in the commodities market. Any purchase represents a transaction in a non-income producing commodity and is highly speculative. Therefore, commodities should not represent a significant portion of an individual’s portfolio.
The uneven markets we anticipated at the beginning of the year have not yet materialized. This has been a boon for both investor sentiments and account values. When equity prices rise at an accelerated pace, as we have seen in the first quarter of 2012, by nature we at Magellan Financial become skeptical about the sustainability of the rally and begin to take a long, hard look at what could possibly go wrong. While we do believe markets will be strong this year, we have become increasingly cautious in the short-term. Earnings season should be interesting, and presents the possibility of a change in expectations. The risks for bond investors continue to remain in the background.
Our cautious stance and the extraordinary short-term market gains lead us to believe that investors would be well served to review their current investments and adjust asset allocations. This will mean something different for each investor and dependent on your individual wealth and investment plan.
We believe prudent investors should consult with a financial professional to gain a greater understanding of the different types of risk within their personal allocation and use this market opportunity to make appropriate adjustments. To many people the only definition of “risk” is market volatility. In reality, risk is a much more complex subject.
Past performance is no guarantee of future results.
Indices are unmanaged and you cannot invest directly in an index.
The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market value weighted index with each stock’s weight in the Index proportionate to its market value.
The Dow Jones Industrial Average is an unweighted index of 30 “blue-chip” industrial U.S. stocks.
The Market Volatility Index (VIX) is an index designed to track market volatility as an independent entity. The index calculated based on option activity and is used as an indicator of investor sentiment, with high values implying pessimism and low values implying optimism.
The Thomson Reuters/Jefferies CRB Index (TR/J CRB) is a commodity price index. It Is currently is made up of 19 commodities as quoted on the NYMEX, CBOT, LME, CME and COMEX exchanges.
This and/or the accompanying statistical information was prepared by or obtained from sources that Magellan Financial, Inc (Magellan Financial, Inc is a separate entity from WFAFN) believes to be reliable, but its accuracy is not guaranteed. The report herein is not a complete analysis of every material fact in respect to any company, industry or security. The opinions expressed here reflect the judgment of the author as of the date of the report and are subject to change without notice. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy.
Additional Information is available upon request.
Jonathan D. Soden Robert I. Cahill
Partner Managing Partner
Ann L. Drescher Jeffrey T. Bogert