Market Commentary – January 4, 2012
Attractive stock market valuations trump European banking fears
Reviewing the headlines over the last year, it would be easy to conclude the stock market should have suffered a significant decline. Yet, the S&P 500 price index gained 11% for the last quarter, and finished unchanged for the year (+2% including dividends). The flat year for stock prices was far from
mundane, as our list of notable observations indicates:
Economic sector performance was led by Utilities, Consumer Staples, and Health Care. These are often perceived to be defensive, less volatile sectors. Staples and Health Care were purposeful over-weights in our equity portfolios all year. Financial companies, which were the worst performing sector, have been on our avoid list since June, 2007. Even though our equity portfolio returns trailed the S&P 500 for the year, our sector allocations were a positive in uence on returns for 2011.
The S&P 500 finished virtually unchanged for the year, which is something of a statistical anomaly when you consider the performance of the underlying sectors. It reminds us somewhat of our first days in Statistics 101 when we were taught that you can drown in a river with an average depth of six inches. However, when we look deeper into the "river" that was 2011, there are a few clear themes that begin to emerge. Stock price changes were highly correlated and daily market volatility increased due to macroeconomic issues that had little to do with the valuation of individual companies.
Equity markets in 2011 were often driven by news headlines generated out of Washington and Europe. This headline risk drove stock prices lower by over 2% on multiple days. However, these declines were frequently erased with robust gains in very short order. August was the only month with a double digit decline, yet it was followed by one of the best October market rallies in history. Increased daily volatility was not clearly evident in the performance of the equity market for the year.
Market volatility can be measured in multiple ways. A simple chart of the daily percentage change of the S&P 500 price index shows the clear increase in volatility in the second half of the year.
And daily stock price correlation also increased in the second half of the year. When more than 90% of the S&P 500 stocks move the same direction on any given day, we label it as a "one-way day".
Keeping in mind there are 22 trading days per month, half of the trading sessions between August and November were "one-way days". The 69 "one-way days" for 2011 is a record, eclipsing the roughly 50 each in 2008, 2009, and 2010. Furthermore, 69 "one-way days" exceeds the total recorded over the entire 15 year period from 1990 to 2004.
We think that Mohamed El-Erian, CEO of PIMCO, summed it up well recently, "Every week, if not every day, Europe influences stocks, overwhelms security-specific news, and frustrates careful security selection. The result is wave after wave of manic risk on and risk off days, together with spiking correlations and unsettling volatility."
Equity Fund Managers
The increased daily volatility and high correlations that moved essentially all stocks in the same direction on a large number of trading sessions proved to be a very difficult market environment for equity fund managers, as illustrated by our estimate of mutual fund category performance in this table.
Stock prices in 2011 were also heavily in uenced by trends in the currency markets. As measured by the U.S. Dollar Index over the entire year, on 69% of market trading days, the stock market moved exactly opposite the dollar index. When the dollar was strong, stock prices typically declined. Conversely, when the dollar was weak, stock prices often increased. During the more volatile last five months of the year, the correlation increased to 77%.
In the third quarter, European banking fears held the upper hand and drove U.S. equities lower. But in the last quarter, attractive stock valuations trumped those fears and we experienced one of the best October stock market rallies in history. Throughout the volatile last ve months, however, one thing is clear…investors perceive value in the equity market, as each time governmentrelated headlines drove prices lower, buyers stepped up. The EAFE index (which is comprised of large companies in Europe,Australia and the Far East) was heavily impacted by the European component due to its continued sovereign debt crisis.
Europe – Why it Matters
Italy is a good example of the problems potentially facing the U.S. bond market. Investors had for years priced Italian debt at only a small discount to German and French debt. However, once the Italian economy slowed, and debts piled up relative to the size of their economy, bond yields started rising. With a heavy debt load, re nancing maturing debt at 7% instead of 3.5% suddenly made their fiscal deficit that much worse. Their only choice to address the messy scal situation is austerity through higher taxes and lower government expenditures. Austerity slows the economy in the short-run, thus creating another burden on the total debt load. A recession in Europe would negatively impact economic activity in the U.S., as sales to Europe represent 17% of our total exports.
Earnings
Corporate America continues to perform well. Earnings have improved steadily, though not well recognized in the media as headlines have been dominated by government issues in Washington and Europe. With 3 of the 4 quarters finalized and estimates for the last quarter, we can observe:
The improvement in earnings while stock prices su ered under negative news ow moved the trailing P/E ratio to 12 as of September 30th. Currently it stands at 13.3 – still toward the lower end of its historical range. The only period with consistently lower P/E ratios was the high in ation, high interest rate 1970's.
Equity Holdings
In December we implemented changes to the equity holdings across the portfolios. While our sector targets remain similar, we sold selective holdings and replaced them with funds that we expect to perform better in the future. We continue to target large and mid-cap companies, with an emphasis on growth over value. Our sector valuation discipline targets over-weightings in the technology, health care and consumer staples sectors. We continue to under-weight nancial companies, as we have since June, 2007.
Asset Allocation
Our asset allocation discipline compares the valuation of stocks versus bonds, allocating investments to the asset class that o ers the best prospect for long term returns. The major components of the discipline are stock prices, corporate earnings and interest rates. The targeted equity exposure of 60% remains unchanged since we reduced it last April from a 70% allocation. P/E ratios are historically low and interest rates are not competitive. So (as we stated in our October commentary) current valuations support an increase in equity exposure; yet the highly volatile stock market continues to su er under two signi cant clouds. The rst is that scal imbalances in the United States continue and secondly, the sovereign debt crisis in Europe is severe and unresolved.
Interest Rates and Bond Markets
Short term interest rates in the United States will remain low as long as the Federal Reserve perceives a need to stimulate the economy. Even the Fed has suggested this could require another 18-24 months. Long term interest rates will remain low until either a.) the market starts sensing a problem with rising in ation, or b.) foreign purchasers of our debt become nervous about our long term scal health. The latter circumstance is not unlike what has happened in Italy. We are not in the same debt position as Italy yet; and we control our own currency. However, if our scal condition is not addressed with a long term solution, we will be faced with rising long term rates - which could have a significant negative impact on our Federal Budget. Regardless of the reason and the timing, interest rates will rise at some point. Given the current level of interest rates and the 30 year bull market in bonds, fixed income investors with long duration portfolios will experience disappointing returns at some point in the future, when rates turn higher.
As we enter 2012, there is much reason for optimism within the equity markets. Earnings are improving, stocks are inexpensive, interest rates are low and central banks in all major countries are either maintaining or moving towards easing monetary policies. All of these factors combine to support continued strength in the equity markets. The headwinds continue to be the same we experienced in the third quarter…the scal position in the United States and the sovereign debt crises over in Europe. Both can be resolved in a way that will not crater the global economy. However, until long term solutions are implemented, the markets will continue to be subjected to increased risk levels and volatility. To end on a positive note, the improvement in corporate pro ts and attractive valuations of U.S. equities should continue to cushion market corrections as we have seen over the last 6 months.
Our best wishes for a healthy and prosperous New Year.
Your AAMA team.
The information and opinions in this report have been prepared by the investment sta of Advanced Asset Management Advisors (AAMA). This report is based upon information available to the public. The information herein is believed to be reliable and has been obtained from sources believed to be reliable, but AAMA makes no representation as to the accuracy or completeness of such information. Opinions, estimates and projections in this report constitute AAMA's judgment and are subject to change without notice. This report is provided for informational purposes only. It is not to be construed as a recommendation to buy or sell or a solicitation of an o er to buy or sell any nancial instruments or to participate in any particular trading strategy in any jurisdiction in which such an o er or solicitation would violate applicable laws or regulations.