Market Roundup - May 2012
May: Don't go away
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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There is an old saying—so old, in fact, nobody really knows its origins—“Sell in May and go away.” It raises a couple of questions—namely, “When, exactly, in May should I sell?” and “When should I buy back in?” Direction is given in one variant, which states: “Sell in May and go away, but buy again on St. Leger Day.” St. Leger Day is named for the St. Leger Stakes, which is a horse race in England named, in turn, after Lieutenant General Anthony St. Leger. The race dates back to 1776 and is traditionally run during the second weekend of September. Traditionally, it marked the end of the summer holiday season.

Selling in May and buying on St. Leger Day may work some years, but it’s an unreliable strategy. While it’s true that, on average, stock market returns are slightly down from the first day of May to the second weekend of September, the variability of returns around the average is great. Quite a few times the markets have been up significantly during the May to September time frame. Also, September is—on average—the worst month for the markets, so buying in September after a summer on the sidelines might be dangerous to one’s portfolio.

The fact is that, just as buying stocks or bonds is an investing decision, so is selling stocks or bonds and going to cash. The decision not to invest is, in itself, an investment decision. Even if May proves to be a volatile time for the markets, we think the opportunities are too numerous to ignore. Another adage might be apropos: “Volatility brings opportunity.”

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


Brian Jacobsen photo

The economy

By Brian Jacobsen

In April, we received a slew of weak economic data. Actually, the data wasn’t all bad, but it was weaker than data from the previous few months, which, from December to March, might have been distorted by milder-than-normal weather. Few things get shoppers shopping like discounting and decent weather. Similarly, the warmer weather may have contributed to labor market figures being more positive than they might have been because construction is a bit easier when the weather is warmer. So some of the weakness in April was payback—and we could see some continued payback in May.

The economy appears to be having difficulty accelerating out of the rut it is in. A broad measure of economic activity—real gross domestic product (GDP)—is 1.3% higher than its December 2007 level. Other measures, however, such as payrolls, industrial production, and personal income less transfer payments, are still lollygagging below their prerecession levels (see Chart 1). This is not to say that the U.S. economy is poised to fall into a recession, but it is precariously balanced and could be pushed into one through a policy blunder, such as an unhealthy fixation on austerity through tax increases and dramatic spending cuts instead of a more gradual approach to fixing the federal fiscal situation.

Chart 1: Economic indicators have seemed to stall at levels below their prerecession values

Source: Federal Reserve Economic Data and authors’ calculations

The housing market has been more of an albatross around the neck of the economy than an aid. From nearly 6.3% of GDP in 2005, it has fallen to a near-historic low at 2.3% of GDP (see Chart 2). The problem is not just that too many houses were built (a supply problem) but that there has been a collapse in household formation (a demand problem). In 2010, according to the Census Bureau, there were 131.7 million housing units but only 114.2 million households. There are only so many second and third homes people can buy!

Chart 2: Residential investment has fallen and shows few signs of improving

Source: Bureau of Economic Analysis and authors’ calculations

The recent spate of weak data has probably made people wonder if we’ll have a third year in a row of a sputtering economy during the summer months. We think that this is a risk, but it is more likely than not that the economy will continue to plow forward at a slow pace. The indicators this year are better than they were over the past few years, and that better starting position could make a huge difference. Payrolls have continued to expand—slowly—and industrial production has continued to increase—also slowly. However, combined with the still-strong retail sales numbers, job creation, we believe, should continue at a moderate pace.



John Manley photo

Equities

By John Manley

For three years, and with good reason, the equity market has been expecting the arrival of some sort of unexpected bad news at any moment. For three years, the Federal Reserve has sought to alleviate that anxiety (and get investors to take risks) by pushing massive amounts of money into the system and debasing the potential returns of “risk-free” investment vehicles by driving them toward zero.

The result has been a tug of war between the forces of light (as I will call the bulls)—which are making good, if uneven, progress—and the forces of darkness (you bears will recognize yourselves). The equity market’s modest valuation and surprisingly good earnings results along with the anticipation of disaster have set the default  to “up.” Powerful monetary forces have pushed prices higher in the absence of—not in spite of— bad news.

Stocks have not been immune to bad news, but they have tended to move higher when things are quiet. The result has been a tape that resembles an unfinished stairway: a gradual ascent, terminating in a rapid decline. Even more than usual, we are at the mercy of the future and its unknown events.

The news was not bad in April, but it was dark enough to slow the first quarter juggernaut and deflate equity prices slightly.

The many situations in Europe, which had shown signs of meaningful progress in the first quarter, reminded us in April that the “old world” is far from a settled place. A number of countries that had initiated restrictive fiscal policies saw their economies dip or double dip into recessions. The obvious pain caused by those policies flared up in British opinion polls, a French election, and the collapse of the Dutch government. The Greeks seemed particularly restive, and Spain had some issues as it tried to issue new debt.

When coupled with further signs of slowing in India and indications of abating growth in the United States, these events offset positive first-quarter corporate earnings results and gave a slightly downward tilt to equity prices and risk appetites.

The S&P 500 Index dipped 0.6% in April, but it is still up almost 12% year to date. The Dow Jones Industrial Average was essentially flat. Smaller stocks lagged a bit; the Value Line Composite Index (geometric) declined 1.8%. The Russell 1000® Index slightly beat the Russell 2000® Index and the Russell 3000® Index. Within the Russell 1000, growth did noticeably better than value. The Nasdaq Composite Index’s decline of 1.5% was possibly influenced by a pullback in its largest component, Apple Inc.

The sectors showed a bias toward visibility and noncyclicality. The high-yielding telecommunication services sector led with a 5.4% jump. Utilities added 1.8% after lagging noticeably in the first quarter. Consumer staples added 0.3%, but health care slipped 0.2%. Surprisingly, consumer discretionary gained a healthy 1.3% in April, as the U.S. economy seemed less troubled than those in other parts of the world.

On the downside, materials, industrials, and energy all lost approximately 1%. The biggest loser was the financials sector, down almost 2.4% on concerns about the fate of Europe. Despite low valuations, we remain nervous about the sector’s prospects going forward.

In summary, we are impressed by the ability of corporations to deliver results in a trying environment. In our opinion, this will prove more important to equity prices over the next several years than other factors that now seem to cast a long shadow.



James Kochan photo

Bonds

By James Kochan

The Treasury market rebounded in April because the markets in Europe deteriorated yet again, but it is still the weakest-performing sector thus far in 2012. The sectors with the best coupon income continued to deliver the best year-to-date total returns (see Table 1).

Table 1: Bond market total returns (%)
Market 2009 2010 2011 April YTD
 
Broad market index 6.12 6.80 7.80 1.14 1.51


Corporate 19.76 9.52 7.51 1.28 3.75


Treasury -3.72 5.88 9.79 1.53 0.22


Agency 0.90 4.61 5.27 0.75 0.73


Mortgage 5.76 5.67 6.14 0.68 1.29


Asset-backed 10.62 5.02 1.43 0.25 1.01


High-yield 56.28 15.24 4.50 1.02 6.22


Municipal 14.45 2.25 11.19 1.11 3.21


2-year Treasury 1.05 2.28 1.45 0.16 0.07


5-year Treasury -1.47 6.76 9.20 1.29 0.76


10-year Treasury -9.71 7.90 17.15 2.89 0.59


30-year Treasury -25.98 8.65 35.50 4.81 -3.13


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

Considerable debate has been heard about how the Treasury market might perform if the Fed ends its Operation Twist without implementing another form of quantitative easing. In fact, however, the strength or weakness of foreign demand has been much more important to that market than Fed policy. Monthly total returns from the Treasury market have been almost perfectly correlated with the monthly data on foreign purchases. In April, the market for Spanish debt was in turmoil, the euro weakened, and Treasuries rallied. April was the first month this year that the longer maturities recorded positive returns.

Because the equity market struggled during most of April, the high-yield bond market underperformed somewhat. As is typical for such a period, the CCC and weaker credits underperformed the BB and B sectors in April. Year to date, the CCC sector has recorded a return of 10.1%, which was substantially better than the returns of 5.3% and 5.8% for the BB and B credits, respectively. As is true for most markets, the longer maturities had substantially better year-to-date returns. The 10+ high-yield index had a year-to-date return of approximately 8% versus a return of 4% for the one- to three-year index.

Among investment-grade corporates, the BBB credits had year-to-date returns that were double the returns from AA/AAA credits. And the market for bank debt behaved much like the high-yield market. In April, the rally in bank debt slowed, and that sector returned only 0.7%, while industrials returned 1.5%. In contrast, year-to-date returns were 6.2% for banks and only 2.8% for industrials. Even after this stronger year-to-date performance, yields on bank debt remained 50 to 75 basis points (bps) above yields on comparably rated industrials. In the years prior to the financial crisis, bank and industrial credits typically offered the same yields.

Thus far in 2012, the performance of the municipal market followed the typical seasonal pattern. The market recorded strong returns from January through February, when new-issue calendars were light, and then experienced negative returns in March, as calendars increased and the tax dates approached. Once the tax dates passed, the market recovered, producing positive returns in April. In April, returns were fairly uniform across credit quality, but year-to-date returns for the A/BBB credits were 200 bps better than returns from the AAA/AA credits. Because yield curves were steep, the year-to-date returns on the 10+ maturities were 400 bps better than returns from the one- to three-year maturities.



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
From our perspective, even with the decent run-up in the equity markets in the first quarter, stocks still represent good long-term value, especially relative to fixed income. We have been expecting volatility to return, but it seems late in coming. In the meantime, while high-yield fixed income might not offer substantial capital appreciation potential, it can provide some decent income.

 

Equities
With continued and prospective austerity measures in Europe, we prefer U.S. equities and some select Japanese exposure for developed market exposure. Despite the slowdown in China, we think emerging markets can present strong growth opportunities, but some of those opportunities are probably better tapped through U.S. equities rather than directly in the emerging markets. Some of our favorite long-term investments are U.S. consumer staples and health care stocks, which carry a sense of status and quality in the emerging markets. Broad and sweeping allocations to emerging markets may prove to be excessively volatile, but a prudent and well-researched exposure to emerging markets could pay dividends. We are growing increasingly skeptical about the health of the Chinese financial system, but we are hopeful that the country’s five-year plan may bring about important political as well as economic reforms.

 

Value versus growth
There appears to be increasing skepticism about the sustainability of the pace of global economic growth. We understand that skepticism, especially given the potential for further austerity measures in Europe and the possibility that the U.S. government will allow the past 10 years of tax policy to lapse. However, we think this simply means investors will eventually pay up for companies that can deliver real growth in a slow-growth environment. We believe those companies are primarily in the U.S. consumer staples, health care, and information technology (IT) sectors. Even U.S. financials could grow as their European counterparts shed their crown jewels.

 

Large caps versus small caps
While we prefer large-cap stocks, since they are the ones most likely to be able to penetrate new markets or grow their market share in existing markets, we do not recommend a heavy overweight because there are many selective opportunities in the small-cap space. 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. It’s not just size or cash hoards that matter, but also the quality of management. That sort of information only comes from bottom-up stock selection, not just broad sector allocations.

 

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 summary table
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, though Japan may surprise to the upside as it pursues its new monetary easing.   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. This could create significant uncertainty about the sector’s outlook. We also think investors will pay up for real growth, which could be hard to find.   Unbiased between value and growth, provided the value portion of a portfolio is not benchmarked to the financials sector. There are short-term opportunities in the traditionally “defensive” sectors like consumer staples and health care.  


  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, despite the Fed’s statement that it projects conditions will warrant keeping rates exceptionally low until late 2014. We do need to remind investors that “exceptionally low” does not necessarily mean zero. Even 2% would be exceptionally low.   Intermediate-term, because rates won’t likely rise until the middle of 2013, but abating fear could push Treasury yields higher. There seems to be a decent cushion in corporate and municipal spreads to withstand a move up in Treasury yields.  


  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. Rates will likely rise, 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

We’re looking for volatility in May, but not because of economic data. The volatility we’re looking for is likely to be front-loaded in the month, with the May 6 elections in France and Greece. In France, it looks like the socialist contender for the presidency will defeat the incumbent, Mr. Sarkozy. Mr. Hollande, who we think will win, has pledged to raise taxes on the rich and renegotiate the various agreements that have tenuously kept the eurozone together. In Greece, the parliamentary elections could show that the bailouts and austerity pledges that have kept Greece in the eurozone don’t have overwhelming support. This isn’t to say that the eurozone will fall apart in May. In fact, we think the eurozone is likely to live to see its next crisis—though that crisis is likely a few years away. Regardless, the volatility we saw in the markets from August to October of 2011 could be repeated, albeit a bit earlier this year than last.

Despite our expectation that conditions will likely get worse in Europe before they get better, we think the backdrop for investing in select emerging markets and in the U.S. remains positive. Our big concern with the emerging markets is illustrated by what happened in Argentina. Ever since the late 1940s, leaders in Argentina have struggled to maintain an investor-friendly environment. Too often, however, the leadership has done an about-face to win re-election, to the detriment of foreign investors. In April, this was demonstrated again with the expropriation—that is, the government takeover—of YPF, an oil company. Emerging markets equities typically trade at a valuation discount to developed market equities because, in part, emerging markets pose more political risk than do developed markets. But—as we discussed in our 2012 Outlook—we’re all emerging markets now, thanks to the political changes that are afoot all over the world, including in Europe and the U.S.

 


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