Nearly all categories of financial investments posted strong gains during the January-March quarter. Major U.S. stock benchmarks rose more than 10% for a second-consecutive quarter, finishing the period more than 25% above early-October lows. Overseas stock markets, on average, also saw three-month gains of around 10%, while many real-estate securities provided even stronger results; commodity-related investments (including gold) rose more modestly. Bond yields drifted moderately higher from record lows (the 10-year Treasury Note ended the period at 2.21%, compared with 1.87% at the end of 2011); most categories of bonds still turned in positive three-month returns.
Among U.S. stocks, the strongest results came from companies in the Capital Goods, Financial Services and Technology sectors. Consumer Staples, Health Care and Utility stocks lagged. Small-company stocks as a group posted marginally better gains than large-caps, while value-oriented stocks edged out those in the growth category.
Benchmark Performance – Equities
|First Quarter 2012||Last Twelve Months|
|S&P 500 Index||+12.6%||+8.5%|
|Large-Cap. Core Mutual Fund Avg. (Lipper)||+12.4%||+5.7%|
|Small-Cap Stocks (Russell 2000)||+12.4%||-0.2%|
|Non-U.S. Stocks (MSCI ACWI ex-U.S.)||+11.8%||-6.8%|
Benchmark Performance – Fixed Income
|First Quarter 2012||Last Twelve Months|
|Barclays Intermediate Gov’t/Credit Index (taxable)||+0.7%||+6.2%|
|Barclays Municipal Bond Index (tax-exempt)||+1.8%||+12.1%|
Two unambiguously positive developments – an easing European sovereign-debt crisis and a firming U.S. economy – dominated the financial markets during the first quarter. These salutary trends overshadowed concerns about flagging emerging-market growth, rising tensions in the Middle East, surging gasoline prices, and a surprisingly eventful U.S. primary election season.
It gradually became clear during the January-March period that the European Central Bank effectively ‘rescued’ the European banking system with its December decision to make available essentially unlimited three-year loans to member banks. With this program in place, the most-feared scenario of a continent-wide banking-system collapse was effectively vanquished. While this ‘solution’ did little to mitigate the solvency problems of the peripheral European economies (in particular, Greece and Portugal), it did buy time for both smaller nations and larger ones – especially Spain and Italy – to sort through complicated political issues and decide on their own individual courses without the distraction of looming disaster.
Meanwhile, the firming trend in U.S. economic data that emerged during the final three months of 2011 was extended and broadened. Purchasing-managers and consumer-confidence surveys showed sustained, albeit moderate, optimism; the index of Leading Economic Indicators notched three consecutive monthly gains; consumer borrowing turned distinctly positive; and the housing market, though still depressed, posted some of the least-weak figures since 2007. The best news, however, came on the employment front, where initial claims for unemployment insurance plummeted, and monthly job creation averaging nearly 250,000 was sufficient to knock nearly a full percentage point off a still-elevated unemployment rate (which ended the period at 8.3%).
Against this supportive backdrop, nearly all ‘risk assets’ extended rallies that had begun in October. Stocks were also boosted by another solid gain in corporate profits: fourth-quarter 2011 earnings for the companies comprising the S&P 500 Index were some 8% higher than a year earlier. Measured volatility receded dramatically (which had not been the case in the October-December phase of the rally), reflecting palpable relief that a Lehman-style meltdown of European banks had been averted. In this heady, ‘risk-on’ trading environment, the market valuation of Apple increased by nearly 50%, surpassing $500 billion and making the company easily the most valuable on the planet – all despite the October death of the company’s founder/guru, Steve Jobs. Unsurprisingly, bond yields – particularly those associated with ‘safe-haven’ assets like U.S. Treasurys – backed up, though the rise was insufficient to pose much of a headwind for other financial assets.
To provide insight regarding recent stock market performance, we can deconstruct the three-month return from stocks into three components:
1) Dividend Income (for three months this is the annual yield divided by four)
2) +/- Change in Earnings per Share* (average for S&P 500 companies)
3) +/- Change in Valuation (Price/Earnings Ratio)
= Total Return
* based on forecast earnings for next 12 months (Source: S&P Outlook)
So, what changed during the recent quarter to give us the +12.6% S&P 500 total return?
|First Quarter (January-March) 2012|
|+ Change in Earnings||+4.6%|
|+ Change in Valuation||+7.5%|
|= Total Return||+12.6%|
Our read: Although earnings continue to grow at a healthy clip, the market’s advance over the past six months has outpaced them, leaving valuation less compelling (though not yet expensive).
The first-quarter performance of different stock-market sectors was unusually divergent, and followed an unexpected pattern. Higher-risk, more economy-sensitive sectors (e.g., capital goods, financial services, technology) greatly outperformed more consistent, higher-dividend-paying names in areas like consumer staples, health care and utilities (which had been in favor through much of 2011). This shifting pattern, atypical in a mature bull market, led some observers to opine that – following the August-October market swoon that just grazed the minus-20% threshold generally associated with a bear market – the post-October rally might actually be a ‘new’ bull market. Stay tuned.
Looking ahead to the remainder of 2012, several key storylines seem likely to influence the financial markets. Probably most important will be whether (or not) the recently improved pace of U.S. economic activity is sustained. Growth trends abroad will be a second area to watch, with both Europe and major emerging markets in a state of flux. The nuclear standoff with Iran and the uprising in Syria will also bear close monitoring. And finally, shifting perceptions of the likely outcome of the November election could have important incremental effects on the markets.
We have now seen six months of steady improvement in many measures of domestic economic activity. But since the current expansion began in 2009, the U.S. economy has experienced several firming periods of similar duration, each eventually giving way to a slowdown that rekindled fears of a ‘double-dip’ recession. A more durable, sustainable expansion requires confidence – among consumers, business leaders and investors. And building confidence requires a healthy job market, stable or rising asset values (financial and real-estate), and a positive outlook for disposable income – largely a function of prices (inflation) and taxes. At this juncture, the financial markets are supportive, real estate is becoming less of a drag, and the job market, while far from robust, has begun to look meaningfully better. But the recent spike in gasoline prices and ongoing uncertainty surrounding fiscal policy (i.e., taxes and spending) are obvious hindrances. Many observers believe house prices are near an inflexion point, and will be rising before long. We also suspect, barring a worsening confrontation with Iran, that subdued global growth (see below) will allow energy prices to moderate later in the year. If these assessments are accurate, the recent firming trend may prove more durable than its predecessors.
Some say that every silver lining has its cloud. If U.S. growth becomes self-sustaining, it will not be long before a clear tension arises between an obviously healthier economy and the Federal Reserve’s ‘pledge’ – which is very supportive of financial asset prices – to keep short-term interest rates near zero. This tension would likely cause bond yields to rise fairly dramatically, which could lead to price ‘corrections’ in other financial markets. Conversely (and perversely), if growth were to falter, investors would probably begin to anticipate additional Fed easing (‘QE3’), causing bond yields to fall and stocks to rally. We had a hint of this paradox in mid-March, when yields spiked higher and stocks retreated on better-than-expected growth news, only to reverse course when Fed Chairman Bernanke made public remarks indicating he and his colleagues did not believe the U.S. economy was yet out of the woods.
Even if the U.S. economy finds its stride, the situation remains murkier overseas. What lies ahead for Europe is far from clear. A best-case scenario – possibly discounted in the current, ebullient financial markets – would feature a mild and brief recession, and no more than one or two small, peripheral nations dropping out of the currency union. More worrisome would be a return of financial-market dislocations and a deeper downturn that caused additional, more important nations (Spain and Italy, for example) to re-evaluate their commitment to the ‘one-Europe’ project. The looming French presidential election is another wild-card – a Socialist victory would call into question France’s willingness to continue working in concert with Germany to solve the continent’s intermediate-term problems. In any case, the current lull in the European drama seems destined to be replaced by new concerns, the gravity of which we will be monitoring closely.
Though it remains the world’s largest economic entity, Europe never figured to be a near-term ‘engine’ of global growth under any scenario. The same cannot be said for the major emerging-market economies – China, India and Brazil. Home to some 40% of the world’s population, these three developing giants have assumed an increasingly pivotal role in a deleveraging, post-financial-crisis global economy. And as noted above, all are experiencing growth-related challenges. India, beset by increasingly fragmented and ineffective government, has seen growth slow and fiscal imbalances worsen. Brazil, also hamstrung by a swollen state sector, has recently been impeded further by an appreciated currency that has hurt its international competitiveness (though it has made Miami Beach real estate affordable to thousands of Brazilian buyers). Finally, China, with its state-managed-capitalism model, is easily the most opaque of the lot. Authorities there have been trying to cool a too-hot real-estate market; there were ample signs during the January-March quarter that this campaign, combined with the downturn in European export markets, has slowed overall growth more dramatically than planned. How these three economies navigate the remainder of 2012 will have a meaningful impact on global growth, commodity prices and the earnings of multination companies – all key inputs to investors’ pricing models for financial assets.
As headlines raised the specter of Israeli airstrikes against Iranian nuclear facilities, we puzzled at how little angst seemed reflected in the behavior of financial markets. Whether this lack of concern reflected cool-headed analysis of the likely fallout (pun intended) from any potential hostilities or imprudent complacency is difficult to gauge. Estimates peg the current ‘Iran premium’ in the oil market at around $10 per barrel, a figure that could swell to $50 or more in a shooting war. Though recent developments suggest the Israelis have been persuaded to allow some time for newer, stricter economic sanctions to take hold, Tel Aviv’s patience is not infinite. Moreover, recent White House policy clarifications indicate that, regardless of the election outcome, there is a growing likelihood that the U.S. military will at some point become engaged in yet another Middle East conflict. The ebb and flow of news on this front, too, looms as a potential threat over the remainder of 2012.
Finally, handicapping the November U.S. elections will surely be an important preoccupation (or should we say distraction?) for market participants. It seems to us that the big issue investors should want Washington to address is the untenable intermediate-term (i.e., beyond 2018 or so) fiscal imbalance. As this chronic problem is the bi-partisan product of deviations from historical norms with regard to both spending and taxation, exacerbated by intractable non-partisan demographic trends, it is not obvious (to us) which party would address it most effectively. In the meantime, the unsatisfactory outcome of last summer’s debt-ceiling debacle – also the product of bi-partisan dysfunction – more or less ensures a similar white-knuckle negotiation to avert drastic fiscal austerity (tax increases and spending cuts) in 2013. These related issues – one threatening the outlook for long-term growth, the other casting a shadow over the near term – have potential to unnerve investors as we move through the year.
Given the six-month rise in financial-asset prices, the foregoing list of concerns may seem daunting. However, the old adage about the stock market needing to climb a wall of worry seems apt. Moreover, valuations do not seem stretched, suggesting that unpleasant outcomes in one or more areas may cause only a minor set-back. Still, we believe that cautious optimism rather than full-blown exuberance is in order, and we will manage your portfolio accordingly.
Alan Purintun, CFA Robert W. Phelps, CFA
Principal & Portfolio Manager Principal & Portfolio Manager
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Milwaukee, WI 53202
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