A Slow Start to the New Year
February 1, 2010
After ten months of steady progress, global stock markets cooled off in January as several factors came together to dampen investor enthusiasm.
The Dow Jones Industrial Average declined 3.5% in January while the S&P 500 and Russell 2000 Small Cap Index were lower by 3.7%. The technology heavy NASDAQ Composite Index fell 5.4% after posting the highest returns in 2009. Internationally returns were even less attractive with the MSCI EAFE (Europe, Australia and Far East) Index down 5.1% and the MSCI Emerging Market Index off by 7.8%. Returns from international investments were negatively impacted by the recent rally in the U.S. dollar which dampened returns to U.S. shareholders from non-U.S. dollar denominated assets. Keep in mind that all of these benchmarks are up 25% or more from this time last year and by more than 40% from the bear market lows touched in March 2009.
Offsetting the decline in stocks was a good month for bonds. The Barclays Aggregate Bond Index moved up 1.5% in the month driven by gains in short and medium term U.S. Treasury bonds, corporate bonds (+2.0%) and municipal bonds (+.5%). Emerging market bonds also were positive in the month posting an advance of .7% despite lingering effects of the Greece sovereign credit rating downgrade. The U.S. Treasury yield curve remains very steep at this time with short-term yields more than 260 basis points lower than long-term yields.
As we mentioned initially, several major factors came together to dampen enthusiasm for stocks. First and foremost was the announcement by Chinese banking officials of tighter lending standards and higher benchmark interest rates. China and several other larger emerging markets such as Brazil and India have been leading the world economy out of recession. With tighter monetary conditions and more stringent credit availability, investors are concerned slower growth in China will delay the global economic recovery elsewhere.
A second factor that took life out of the market was the uncertainty originating in Washington. The two most prominent uncertainties were a new bank regulatory proposal from the Obama Administration and the contentious reappointment of Federal Reserve Chairman Ben Bernanke. While we understand the legitimacy of varying viewpoints on these topics, stock markets dislike uncertainty and both of these issues provided plenty.
Third, economic data released in January—primarily the forward looking indicators—are suggesting waning momentum in the domestic economic recovery. Fourth quarter GDP came in ahead of expectations, rising 5.7%, but much of the gains were fueled by potentially non-sustainable inventory adjustments and a strong housing market spurred on by the expiration of the first-time home buyer credit in November (subsequently renewed and expanded through March 2010). Also, as many clearly recognize, there remains little private-sector job creation and, without this underlying support, it is difficult to forecast improving economic conditions overall.
Finally, the corporate earnings season has been reasonably good so far but forward-looking expectations by CEOs in a variety of industries have not conveyed much strength. Moreover, there have been several significantly strong earnings reports from industry leading companies such as Intel Corp. that were greeted with nasty treatment to the underlying stock price. This price action suggests all of the good news may already have been priced in leaving future returns suspect. And a key indicator for renewed stock market strength in 2010 is higher revenue growth. So far, results in this fundamental statistic have been underwhelming across a variety of industries.
With these negatives highlighted, we think it is important to make a few points about the differences that exist now compared with the conditions in the fall of 2007 and early 2008:
1. Unlike the situation that unraveled in 2007 through 2008, credit markets are functioning relatively well. They are not at full health, but are close, and demand for good quality credit remains strong. This is an important consideration. In the fall of 2008, every asset class was being sold off aggressively as massive global de-leveraging took place. Although there remain areas of weakness, many of the problems have been addressed and the excess leverage removed. Having functioning credit markets gives diversified investors a holding that continues to generate positive returns thus offsetting potential declines elsewhere in the portfolio.
2. There remains a significant level of money market reserves on the sidelines. Although markets began to recovery in the Spring of 2009, many retail investors stayed on the sidelines. Having seen the global financial system survive and a broad based recovery in the financial markets for most of 2009, some of these reserves may be looking to buy in for the second phase of the market recovery. We suspect there are some investors who have sworn off stocks for life after the experiences of the past decade, but a portion of those reserves on the sideline is likely to return to the financial markets as the yield on cash deposits continues to dwindle.
3. Equity valuations are not stretched. Given the rally since last March, stocks are no longer cheap, but nor are they over-valued. While it is legitimate to questions the aggressiveness of some of the consensus earnings estimates, the market still trades in the lower half of its historical valuation range on a forward-looking basis. This does not guarantee above-average returns for we may be now in a risk-averse era that assigns a lower multiple to equity earnings. Nonetheless, the lower valuations soften potential declines much like a toddler is built low to the ground minimizing the damage of the early steps.
4. We have been more aggressive and pro-active re-positioning portfolio allocations and incorporating more disciplined risk management techniques. While we remain patient, long-term oriented investors, we recognize the vulnerabilities in the economy, the fragility in the financial markets, and the shaken psyche of the investing public, so we have adopted more short-term oriented practices to minimize down side risk. We have taken time to critique our methodology through the past several volatile years and used those lessons to be wiser more prepared advisors now and going forward.
Overall, with the initial phase of the financial market recovery likely past, we do expect returns to moderate in 2010 as the financial markets adjust to changing fundamentals. However, at this point, we do not expect markets to collapse as they did in 2008. Yes, the U.S. economy is still a long way from full health and set backs are likely to occur in the months ahead, but many of the elements that precipitated the significant across the board declines have been mitigated. We remain very concerned by the everrising U.S. national debt and the potential for even larger deficits ahead, but we think globally so, in fact, we will be looking at any extended pullback in the financial markets as an opportunity to accumulate high quality investments at attractive valuations be they domestic or international.
As always, we will continue to closely monitor market risks and opportunities and provide personalized and customized guidance to help you achieve your financial goals.
Jack E. Payne, CFA
Chief Investment Officer
Michael Joyce, CFA, CFP
President & CEO