Market Roundup - January 2011Ending the year with a bang
By Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist
John Lynch, Chief Equity Strategist
James Kochan, Chief Fixed-Income Strategist
After a tumultuous year for equity investors, stocks rallied in December, boosting their climb in the fourth quarter, to finish the year with impressive gains. In 2010, the S&P 500 Index increased by 12.8% (15.1% including dividends), the Russell 2000® Index gained 26.9%, and the 30-year Treasury bond returned 8.7%. Gold increased by 29.5%, but cotton increased by 91.5%. Natural gas declined by 20.1%. For most markets, the year was a great follow-up to 2009 results. Yet despite the two years of double-digit returns, the S&P 500 Index is just back to where it was in September 2008, right before Lehman Brothers went bust.> The Economy
Along with equity prices, most commodity prices continued to increase in December. This is partially attributable to improved attitudes about economic growth. A growing economy typically results in more demand for the basic building blocks of products. However, we think a lot of this increase is purely speculative, with investors doubling-down on the possibility that someone, somewhere, might be willing to buy at a higher price. That type of dynamic does not typically end well for those who keep piling into the trade.
With the continued increase of commodity prices, there is the possible erosion of the purchasing power of workers’ incomes. That is not as pronounced of a problem in the U.S. or other developed countries where commodities are a relatively small part of the basket of goods and services purchased by consumers, but it is a big concern in emerging economies. For example, in China, the central government is trying to tamp down commodity and real estate price increases by increasing interest rates. Higher rates make it harder to finance the purchases, which is a way to lower demand. China is taking a gradual approach in an attempt to orchestrate a “soft landing,” where the prices get tamed without choking off too much economic growth. Higher interest rates will likely put further pressure on the Chinese central bank to increase the value of the Chinese currency relative to the U.S. dollar. China may ring in the Chinese New Year on February 3 with a slightly stronger currency. Not only would that help with the incipient and actual inflation China has, but it would also help mend some relationships with U.S. politicians who have been clamoring for less currency manipulation on the part of the Chinese government. A stronger Chinese yuan would do little for U.S. exports to China, but it would be a nice symbolic move.
The new Congress
The other major domestic equity market indexes all managed to outperform the Dow 30 on a month-, quarter-, and year-to-date basis. Small- and mid-cap stocks led the way, with gains in excess of 25.0%, while the NASDAQ Composite Index and the S&P 500 Index had total returns (including dividends) of 18.2% and 15.1%, respectively. On an international basis, the developed markets struggled with Europe’s debt woes, as well as attempts by China to dampen inflationary pressures by increasing interest rates and bank reserve requirements. Despite these moves by China, emerging markets returned 19.0% for 2010, as solid economic growth boosted corporate profits and equity market returns.
Considering sector performance in the S&P 500 Index, consumer discretionary led the way, with a 27.8% return for the year, despite our macro concerns related to high unemployment and still weak home prices. Three of our favorite sector picks (energy, materials, and industrials) performed well last year, while technology (10.2%) underperformed the market, as businesses largely sat on cash and governments restrained their technology spending in 2010. Financials and health care were weighed down by regulatory uncertainties throughout the year.
CHART 1: EQUITY MARKET PERFORMANCE AS OF DECEMBER 31, 2010
Consistent with our thoughts written in the 2011 Outlook and our most recent Market Update, “Roundtrip ticket” (December 16, 2010), we believe that stocks are setting up for another volatile year in 2011.
The good news is that the equity market, as defined by the S&P 500 Index, is well positioned both technically and fundamentally to exceed the upper end of the “sustainable trading range” that we highlighted for stocks (1,050 to 1,250) for 2010. Indeed, we believe the combination of firming market technicals and the improvement in market fundamentals may enable stocks to approach, if not exceed, the 1,300 level in the coming weeks.
Yet the bad news is that we suspect that a variety of risks could resurface during the first half of the year that could potentially threaten these hard-fought gains. To be sure, these domestic and global risks are numerous (housing, unemployment, deficit spending, sovereign credit, energy prices, China, Korea, etc.) and could cause stocks to retest the 1,120–1,130 range for the S&P 500 Index. We see good support at these levels, though, and absent a major geopolitical event, they should pose an attractive entry point as investors consider equity prices relative to earnings, book value, sales, and cash flows.
We believe that the combination of low interest rates and low inflation, along with slow but steady growth in gross domestic product (GDP), employment, and corporate profits during the course of 2011, will enable stocks to begin climbing from these levels. As attractive valuations bring new investment, we look for stocks to once again rally above the 1,300 level in the second half of the year. Simply applying a price/earnings (P/E) multiple of 15 times our below-consensus earnings per share (EPS) forecast of $90.00 for the index in 2011 suggests that the S&P 500 Index would be fairly valued in the 1,350 range by year-end.
Given this anticipated volatility, we encourage long-term investors to maintain a fully diversified, actively managed equity portfolio strategy. We recommend a combination of allocation decisions relative to market capitalizations, investment styles, sectors, and regions. Generally speaking, we would slightly overweight large caps over small caps, equally weight growth and value, and use any pullbacks to add to emerging markets exposure over developed markets. On a sector basis, we continue to favor technology, energy, materials and industrials.
A more detailed breakdown of these ideas can be found in our 2011 Outlook and our most recent Market Update, “Roundtrip Ticket” (December 16, 2010).
The 2010 total return for the investment-grade market was close to that of 2009, but the distribution of the returns in 2010 was not the same as the distribution in 2009. Treasuries staged a recovery in 2010 after a terrible 2009, while the municipal market struggled after an exceptional performance in 2009. The high-yield corporate market again outperformed the investment-grade sectors but not by the once-in-a-lifetime margins seen in 2009.
The municipal market was performing quite well until November and December, when it was overwhelmed by supply pressures. Almost daily media stories on the fiscal problems of state and local governments also hurt the market—prompting some individual investors to liquidate positions in municipal investments. Selling by hedge funds also contributed to the poor performance last quarter. These aggressive total return managers have probably contributed significantly to market volatility in recent years. The fourth-quarter return was the poorest since the first quarter of 1994, when the Fed surprised the markets with a 0.75 percentage point increase in the federal funds rate. The 2010 return, however, was much better than the -6.2% and -6.3% returns of 1994 and 1999, respectively. Nevertheless, the muni market starts 2011 cheaper versus Treasuries than any other domestic fixed-income market.The high-yield and investment-grade corporate markets again outperformed the Treasury market by considerable margins in 2010. In both markets, the weaker grades performed the best. The BBB sector returned 10.9% last year versus a return of 7.7% from the AA credits. In high yield, the CCC and weaker credits returned 19.0%, four percentage points better than the BB credits. This left the CCCs as the richest of any of the high-yield sectors versus Treasuries. The fact that the high-yield market produced solid positive returns in the fourth quarter was a reminder that this market is more closely correlated with the equity market than with the Treasury market.
CHART 2: BOND MARKET TOTAL RETURNS
The Fed wanted its second round of quantitative easing to pull down yields on Treasury notes and bonds. Instead, those yields rose sharply in the fourth quarter. That turned a good year into a mediocre year for the Treasury market. By year-end, the market appeared to have priced in expectations of a stronger economy in 2011. This market remains vulnerable, however, to swings in foreign demand. Through the first three quarters of 2010, that demand was strong. In the fourth quarter, demand from overseas appeared to have weakened significantly. With yields now 50 basis points to 100 basis points higher than in early October, foreign investors might be expected to return as major buyers of U.S. Treasuries.
Investors still have enormous sums invested in short-term cash equivalents that are earning next to nothing. That caution potentially cost them four to eight percentage points of interest income over the past 12 months, which they may have earned if they had invested in longer-term securities. The opportunity costs could be just as great in 2011. If GDP growth remains subpar, bond yields could essentially trade within a narrow range, and cash equivalents could again be the poorest-performing assets over the next 12 months.
THE BOTTOM LINE