Market Roundup - March 2012
Déjà vu all over again?
By Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist
By John Manley, CFA, Chief Equity Strategist
By James Kochan, Chief Fixed-Income Strategist
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For a while, we've been trying to determine whether 2012 will be more like 2011 or 2010. Perhaps this year will be completely different from previous ones, but we think the problems that were exposed in the financial crisis (too much debt, a great deal of political volatility, etc.) have yet to be resolved. In 2010, the major volatility began in May with the Greek debt crisis. In 2011, there was initial volatility after the Japanese tsunami in March, but the markets became particularly choppy at the end of July with the restatement of U.S. growth numbers, the debt-limit debacle in the U.S., and further troubles related to the Greek debt crisis. Looking ahead, we could have a mash-up of 2010 and 2011, with many problems coming to the fore in March, such as the Greek debt payment, which is due on March 20, and further issues related to Syria and Iran. In the summer months, the focus could shift to the U.S. fiscal situation as we approach the November presidential election. The quiescence we've had year to date has been pleasant, but perhaps temporary. We believe these issues call for patience on the part of investors, as equities still look inexpensive for the long run. It may be prudent to continue to trim your gains and reinvest in stocks that temporarily go on sale with price declines.

> The economy
> Equities
> Bonds
> Asset allocation
> The bottom line


Brian Jacobsen photo

The economy

By Brian Jacobsen

For 2011, the revised gross domestic product (GDP) numbers revealed that the economy plodded along at a 1.7% pace of growth for the full year, a significant slowdown from the 3.0% rate in 2010. Economic activity seemed to improve as 2011 progressed, culminating in a 3.0% annualized rate of growth for the fourth quarter, which was much better than our forecast of 2.5%. Although it's never fun to be wrong, we were pleasantly surprised by the strong fourth quarter. The revised numbers showed that consumers and businesses spent more than originally estimated, inventory growth was slower, and—perhaps most important—household income was higher. Higher household income will be important for sustaining consumer spending in the face of higher oil and gasoline prices. In light of the new data, we have not revised our 2012 growth forecast of approximately 2.5%, but we have increased our first-quarter GDP estimate from 1.8% to 2.0%. We are not increasing our full-year growth forecast because we think there could be significant resistance going into the end of the year as a number of tax provisions (the expiration of the 2001-2003 tax cuts, the expiration of the payroll tax cut, and the new taxes to help fund health care reform) could result in lower economic activity.

High oil prices also continue to concern us. Oil prices rose nearly 9.0% in February, and the national average for gasoline was $3.74 per gallon at the end of the month—a 10.4% increase from a year earlier. We think much of the run-up in oil prices, and the associated increase in the price of gasoline, is due to fears over increased tensions in the Middle East, including the riots in Syria and the threats from Iran. Based on our forecast, we estimate that gasoline prices could nearly eclipse the 2008 high of $4.11 per gallon. Any economic drag caused by high gasoline prices could be tempered because of the long legacy that high gasoline prices can leave. In response to the previous increase in gasoline prices, consumers modified their behavior and purchased more fuel-efficient vehicles, and businesses spent more on energy-efficient equipment. These changes could make the drag on growth less severe than what we experienced in 2008.

Geopolitical developments

As we entered 2012, we highlighted problems not just from the European debt situation, but also from conflicts in places like North Korea and the Middle East. The European debt situation is still a serious issue, but many of the problems are slowly being addressed. However, we believe a final resolution may take quite a while.

On December 29, 2011, Kim Jong-un took over as the Supreme Leader of North Korea after the death of his father, Kim Jong-il. Any transition of power in a dictatorship creates uncertainty, especially in this case where no one was sure what kind of leader Kim Jong-un would be. Would he be more conciliatory than his father or more provocative?

By the end of February, the new North Korean leader had made some significant promises to the U.S. in exchange for more than 250,000 tons of food aid for his impoverished country. In exchange, the North Korean regime has agreed to stop nuclear testing, uranium enrichment, and the development of long-range ballistic missiles. Unfortunately, the previous regime had also made similar promises with little follow-through. Only time will tell if the environment in North Korea has truly changed.

The two other global hot spots are Syria and Iran. In response to calls for political reform, the Syrian president, Bashar al-Assad, has been violently suppressing an uprising of civilians. While the majority of the members of the United Nations (U.N.) back these reforms, China and Russia have vetoed a proposal for U.N. intervention. Given Syria's location (northeast of Israel), and general opposition to Israel, this could add to the risks of violence coming from the Middle East. Iran has openly defied requests from the U.S. and its allies to shut down its nuclear development program. Iran is the fourth-largest oil producer in the world, with most of its oil going to places like Japan, China, and parts of the European Union (E.U.). The E.U. and the U.S. have imposed sanctions against Iran, and the E.U. governments have agreed to stop importing oil from Iran beginning in July 2012. In response, Iran has banned the export of its oil to France and Great Britain and has positioned warships close to Israel in the Mediterranean. Adding further evidence to the growing tensions, U.S. Defense Secretary Leon Panetta stated that he would not be surprised if Israel were to attack Iran between April and June of this year. The situation is tense and likely to get worse before it gets better, leading us to believe that market volatility could increase dramatically over the next few months.



John Manley photo

Equities

By John Manley

The U.S. equity market continued to surprise its skeptics in February. Despite a wide variety of concerns, several stock market measures rose to levels not seen since 2008. Positive news from Greece and indications of easing monetary policy in China combined to offset fears of rising tension in the Middle East.

The S&P 500 Index returned a healthy 4.3% for the month. While there was no clear preference for large or small capitalization as the Value Line Composite Index (arithmetic and geometric) posted gains of 3.7% and 3.3%, respectively, it was notable that the tech-heavy NASDAQ tacked on a 5.4% appreciation.

Both growth and value did well. However, the Russell 3000® Growth Index returned 4.5%, while the Russell 3000® Value Index returned (only) 3.5%. Adherents of both styles could claim to have fully participated in the strong equity advance. Leading the market were two of our favorite sectors, technology and energy, which gained 7.4% and 5.9%, respectively. The former was probably aided by strong earnings numbers and reduced valuations, while the latter received support from higher oil prices resulting from concerns over the interruption of supplies from the Middle East.

However, our other two overweighted sectors clearly lagged the market. Consumer staples slightly lagged with a 3.6% appreciation, and health care added only 1.3% as a desire to increase cyclical exposure dominated trading. These two sectors were not the worst-performing in the month, a distinction that went to utilities (up 0.3%) and materials (down 0.4%). The utilities sector was probably overlooked as the need for dividend yield seemed less pressing in a rising trend. We find the underperformance of materials somewhat vexing and disturbing for the sector's future outlook.

The financials sector, in which we are underweighted, continued to outperform. The sector rose 5.0%, possibly as a result of easing concerns about European debt.

In February, the S&P 500 Index neared the upper end of our forecasted trading range of 1,250 to 1,375. We continue to believe that it is simply too early for the market to move significantly up or down. While there appears to be clear progress on several of the world's problems, it is hard to believe that many of these issues are on the verge of solution. We tend to believe that these problems are soluble, but we are reminded of the pain that those solutions may bring.

On the other hand, we also see no reason to believe that any sort of collapse is either inevitable or imminent. Central banks and governments still have many tools at their disposal to at least postpone a major crisis. Moreover, we sense skepticism about near-term appreciation, which could temporarily lift the upper end of our expected trading band.

We continue to recommend the accumulation of equities by patient investors. While we think 2012 may be a year of testing for both earnings and price, we do believe those tests will prove successful. We also believe we are in the "healing" phase of the deflationary problem and expect that equity investors could be rewarded with limited risk in 2012, 2013, and 2014.



James Kochan photo

Bonds

By James Kochan

In February, the segments of the fixed-income market that provide higher coupon income performed much better than low-yielding sectors. Treasury yields were near the bottom of their respective ranges at the end of January, and modest increases in February produced negative returns on most notes and bonds. Despite the Federal Reserve's "Operation Twist" initiative, where the Federal Reserve is selling some of its short-term securities and buying longer-term securities, the yield curve steepened slightly, which made the longer maturities the poorest performers.

Table 1: Bond market total returns (%)
Market 2009 2010 2011 Feb. YTD
 
Broad market index 6.12 6.80 7.80 -0.01 0.88


Corporate 19.76 9.52 7.51 0.85 3.05


Treasury -3.72 5.88 9.79 -0.71 -0.26


Agency 0.90 4.61 5.27 -0.13 0.31


Mortgage 5.76 5.67 6.14 0.10 0.52


Asset-backed 10.62 5.02 1.43 0.18 0.54


High-yield 56.28 15.24 4.50 2.28 5.25


Municipal 14.45 2.25 11.19 0.19 2.74


2-year Treasury 1.05 2.28 1.45 -0.13 -0.07


5-year Treasury -1.47 6.76 9.20 -0.61 0.15


10-year Treasury -9.71 7.90 17.15 -1.08 -0.28


30-year Treasury -25.98 8.65 35.50 -2.50 -3.18


Source: Bloomberg
Past performance is no guarantee of future results.

Municipal yield curves also steepened slightly in February, which caused the longer maturities to record slightly negative returns. However, the sharpest return differentials were among quality grades. The A/BBB credit segments recorded total returns of approximately 35 basis points (100 basis points equals 1.00%) better than the AAA/AA segments, continuing a pattern that has been in place for two years. In 2011, for example, the return on an A/BBB portfolio would have been 300 basis points greater than the return on an AAA/AA portfolio.

The same pattern of returns among credit sectors was evident in the corporate market in February. The BBB segment of the corporate market outperformed the AA segment by approximately 50 basis points in February and has outperformed by 150 basis points year to date. Bank debt continued to perform best among investment-grade sectors. Thus far in 2012, the bank index has increased 5.0%, while the industrial index is up 2.3%. In the high-yield sector, the CCC credits outperformed the BB issues by approximately 75 basis points in February and by almost 300 basis points year to date. Spreads to Treasuries for the 10-year high-yield maturities have narrowed by 50 basis points thus far in 2012.

Even in the mortgage market, higher coupon income proved to be important in February. The premium issues performed well last month, while the current coupon index recorded a slightly negative return. In a choppy but essentially trendless market environment, coupon income could continue to be the primary source of total return for much of 2012.

 

Asset allocation

By Brian Jacobsen

Understanding the dials
The shading on each dial face represents the overweight or underweight for our strategic asset allocation recommendations. The needle represents our recommended tactical positioning for investors looking to make adjustments to their portfolios based on current market conditions.1


Overall portfolio allocations
For investors who are following a strategic asset allocation model, we recommend considering a strategic overweight to equities relative to fixed income. Short-term—during the first quarter of 2012—unusually high market volatility should bias a portfolio toward higher-yielding fixed-income assets that can be deployed quickly when the market drops.

 

Equities
Within the equity portion of a portfolio, we prefer a barbell strategy focused on U.S. assets and selective emerging markets assets over the long term. This weighting results in a relatively unbiased portfolio in terms of the equity allocation between developed and emerging markets but a heavily biased portfolio toward U.S. assets and away from non-U.S. developed assets.

 

 

Value versus growth
We prefer growth over value based on the relatively equal valuations given to growth and value stocks and our belief that the U.S. economy is not going to dip into a recession within the next six months (although, if the government decides to let the past 10 years of tax policy lapse, that could change). Further, value indexes tend to be dominated by financials. While we think financials will survive, they may not thrive in the current regulatory environment. As a result, we recommend a heavy overweight to growth and a corresponding underweight to value. We do like the value space, provided that investors don’t try to hug a benchmark.

 

Large caps versus small caps
When dividing the equity universe between large-cap and small-cap stocks, we think large-cap companies are better positioned to maintain profit margins and revenue growth. Input prices are extremely volatile, and credit markets are still not back to normal—although they are returning to normal in the United States. Small-cap stocks also appear to be trading at slightly higher valuations compared with large-cap stocks. While we prefer large-cap stocks, we do not recommend a heavy overweight because there are many selective opportunities in the small-cap space. The large companies with huge amounts of cash on hand will likely look to expand market share or penetrate new markets through strategic acquisitions. As evidenced by some recent acquisitions, executives at large-cap companies may be willing to pay premium prices for acquisitions. For this reason, it will be important to be selective and invest in companies that are making prudent acquisitions.

 

Fixed income
Based on our economic outlook, interest rates are likely to remain low (but volatile) for the next two years. This presents an opportunity for investors to consider taking on additional duration and credit risk. Provided that the economy does not dip into a recession, default rates should not increase, meaning the increased yields on higher-yielding debt may provide better income to investors than the lower-credit-risk issues.

 

Asset allocation recommendation summary
Equity recommendations

        Strategic recommendation   Tactical recommendation  
 
  Developed
equities/
emerging
markets
equities
  Balanced, with 30% emerging markets and 70% developed equities. We prefer strategies that are bottom-up—especially those not tracking the benchmarks, which tend to be dominated by Chinese financials.   Balanced, though we prefer a 20% allocation to emerging markets because we are concerned about the trajectory of the Chinese, Brazilian, and South Korean markets. With capital controls, we fear global investors could be disappointed in these areas.  


  U.S. equities/
non-U.S. developed
equities
  Heavily overweight U.S. equities, which will likely grow faster than other developed countries. Europe and Japan are likely in for a tough journey.   Heavily overweight U.S. equities but with selective Japanese and European industrials and IT exposure—the U.S. will likely grow faster than other developed countries, but industrials and IT appear to have attractive valuations in non-U.S. equities.  


  Value/growth   Heavily overweight growth, only because financials tend to dominate the value indexes and financials could underperform with the enhanced regulatory scrutiny they face, which creates a lot of uncertainty about the sector’s outlook.   Unbiased between value and growth, provided the value portion of a portfolio is not benchmarked to the financials sector.  


  Large/small   Overweight large-cap stocks because they tend to have the dominant market share and cash to survive a volatile environment.   Large-cap stocks are attractive, but some large-cap companies may be tempted to overpay for acquiring small-cap companies.  




Asset allocation summary table
Fixed-income recommendations

        Strategic recommendation   Tactical recommendation  
 
  Fixed-income
duration
  Intermediate-term, although we think yields could rise after June 2013.   Intermediate-term, because rates won’t likely rise until the middle of 2013.  


  Credit risk exposure   High yield. Default rates appear to be low. We believe they will dip lower as the global economy slowly improves.   High yield. Clip coupons, considering that default rates are low and are likely to remain low.  


  Fixed rate/
floating rate
  Fixed rate. Yes, rates are probably rising, but when? Sitting on floating-rate notes for a year or so seems to be overly cautious to us. Floating-rate notes involve paying for insurance that is probably not needed.   Fixed rate. With floating-rate securities, investors are paying for a feature they probably don’t need. It’s unlikely that short-term rates will rise significantly any time soon.  


The bottom line

The soothsayer in Shakespeare's Julius Caesar warned, "Beware the ides of March" (March 15). In 2011, that proved to be useful advice as a natural disaster struck Japan on March 11 and on March 15, the Prime Minister of Japan warned about further leaks from a nuclear reactor, which roiled the markets. We believe there continue to be sound reasons to tread cautiously. Real disposable income (inflation-adjusted income) fell in January, despite 1.4% and 0.7% increases in the fourth and third quarters of 2011, respectively. But business spending on items like equipment and software has been increasing. The employment situation—as shown by a decline in initial jobless claims and positive private-sector payroll growth—is improving. So, there are definitely "positives." It's just that we think there are a lot of lurking "negatives," mainly stemming from a recession in Europe, the possibility of tax and debt problems in the U.S., and the myriad global hot spots that seem ready to flare up. Consequently, we remain guardedly aggressive. We like equities and risky assets for the long term, but we recommend trimming a portfolio around the edges to sell winners and reinvest in lower-priced assets that you want to hold for the long term.

The NASDAQ Composite Index measures the market value of all domestic and foreign common stocks, representing a wide array of more than 5,000 companies, listed on the NASDAQ Stock Market. You cannot invest directly in an index.

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