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Reality Check: Market Highs Always Trigger Overheating Thoughts
May 22, 2013
After reaching new highs in many global stock
markets over the past couple days (at the
time I write this on May 22 morning, S&P 500 is at 1684, Dow Jones at 15518,
Stoxx Europe 600 at 310, MSCI Emerging Markets at 1048), some investors might
be asking “where do we go from here?” Is there more near-term upside in stock
prices or are we due for a “Humpty Dumpty” sizeable pullback? What is the portfolio manager doing lately?
Below are some of the reasons why stock markets have been so strong during the past six months:
1) The Federal Reserve’s monetary policy (quantitative easing stimulus) the past few years has
artificially depressed interest rates in CDs, money markets, safer bonds and treasuries while forcing people into
stocks. Investors became tired of only
1-2% yield for lower-risk fixed income options over the past three years. As January started, much of the “fiscal
cliff” concern was already resolved by Congress.
There was also some clarity on continued quantitative easing. This caused outflows from asset classes with
little yield prospects (money markets and long-term treasuries) into stock markets, real estate and private equity.
Stock valuations were attractively low with dividend yields higher
than yields from 10-year treasuries or money markets. This accelerated “yield chasing rotation” into stocks. Appreciating home
prices and unemployment not worsening help too.
2) Global quantitative easing and monetary policies launched abroad to heal some stagnant and
cooling economies like Japan and other export-dependent countries over past six months. The underlying rational was to
deflate those currencies to make their products and services cheaper for better exports growth, which in turn strengthened the US dollar (one currency
depreciating triggers the counter one to appreciate).
3) The impact of US austerity measure budget cuts was not as bad as feared.
The budget cuts were delayed by 3 months from the actual original implementation
(went into effect late March/early April versus originally expected January 2nd). Then, they were phased in rather than being implemented with a lump-sum shock. This gave businesses more time to deal with
the impact.
As shared in my prior web updates, there has
not been any year in many decades without the S&P 500 pulling back at least
-7% from its prior 12-month peak. At
this point, a “reality check” is needed as we should not become overly complacent
or disillusioned with the recent euphoria or invincibility in stock prices. There have been many good reasons for the
stock market rally mentioned above. Our internal discussions at Cabot focused around what I believed were decent buying opportunities after these market selloffs after .89% market drops. Those drops, when
not due to a banking crisis, are critical periods to avoid capitulating and
selling heavily. Instead, they are rare
opportunities to realize “buying on sale” is better than buying “at or above
MSRP price.” While market timing rarely
works out and should be avoided, what tends to be successful is buying low and
selling high. Not chasing to buy at any high
price just as not shying away at low price.
Buying low and selling high seems like common
sense. However, many investors and
portfolio managers let fear, greed and the media influence their decisions. Buying stocks heavily back in
mid-November made sense to me as I had enough conviction to request a television
appearance. While I would not go on television
today to encourage heavy buying, I take the longer-term view that many (not
all) global stock markets should generate upside from late 2013 through 2014. However, very near-term is murky to me, which makes it
more difficult to find attractive new stocks to buy that still meet my risk/reward
ratio. This is why I have made some
changes in the past couple months to the two strategies I oversee.
In managing our Core Growth and Total
Return Stock Dividend strategies, I have to take a more conservative approach
compared to our Aggressive Growth strategy for different objectives. The downside of my two strategies is that there is less capital appreciation potential compared to Cabot’s Aggressive Growth strategy. The offset is less expected volatility with some yield element (yield is a very significant source of income in our Total Return
Stock Dividend strategy).
As such, I have made a few changes over the past few months. These changes included rebalancing back to more
non-equities in the Total Return Stock Dividend strategy a month ago, adding
more ETFs to the Core Growth strategy to avoid losing individual companies due to
our 20% loss discipline rule in case of a market pullback, trimming six higher-risk holdings and fully exiting two other higher risk holdings. This does not mean that the stock market
cannot climb nicely later in the year and into 2014, but no rally is linear and
uninterrupted for a full 12 months.
Timothy Moore
Portfolio Manager
Surprising Upside
January 29, 2013
STOCKS:
Many investors will be surprised to know that both the
economy and the stock markets seem to be surprising to the upside this month.
The S&P 500 Index is now trading above 1,500, which is a very important
technical level not experienced since late 2007. Stocks seem to have a better risk-adjusted
return outlook over high-quality painfully, low-yielding bonds.
Market Returns 12/31/2012 – 1/28/2013:
Dow Jones Industrial Average = 6.4%
S&P = 5.6%
NASDAQ = 4.4%
Developed Foreign (FTSE All-World Developed) = 4.0%
Emerging Markets (MSCI EEM) = 0.7% Considering the average annual return for the S&P over the last five years
was only a mere 4.4%, this is good news for long-term investors. It creates
optimism for the market that major obstacles will eventually be dealt with
and/or are showing signs of improvement.
BONDS:
The broad US Composite Bond market has slipped into
negative territory this month, sending the 10-year US Treasury Bond yield to
2%, which is a 10-month high. Keep in mind that as a bond’s yield rises, the
price falls. A bond’s yield is one of the best estimates of its expected
return, if held till maturity. With a yield of only 2%, economic conditions
would need to remain flat or decline for the next ten years for this to be a
productive investment. This would require a period of deflation, which is in
opposition to the Fed current policies. Market Returns 12/31/2012 – 1/28/2013:
Merrill Lynch US Treasury Index = -1.0%
Merrill Lynch US Government Agency Index = -0.5%
Merrill Lynch US Mortgage Backed Security Index = -0.5%
Merrill Lynch Corporate Bond Index (BBB) = -0.6% The weak returns and low yields in high-grade bonds are pushing more investors
into either dividend income or bond-like equity securities. The higher-risk
segments of the bond market are all showing signs of strength. The flows into
bond-like equity securities indicate that investors are willing to take on more
risk, believing economic conditions are likely to remain positive.
Market Returns 12/31/2012 – 1/28/2013:
Emerging Markets (Sovereign + Corporate) = 3.2%
Multi-Sector Fixed-Income (Unrestraint) = 2.2%
Merrill Lynch US High Yield Index = 2.0%
Fixed-Rate Preferred Securities = 1.6%
Floating Rate = 1.0%
ECONOMIC ACTIVITY:
Two major events will be unfolding this week that could
potentially have a significant impact on the markets. The first is scheduled
for Wednesday (1/30/2013) when at approximately 2:15 pm the Federal Reserve
will release their target overnight interest rate (0.25%) and their statement
about economic conditions. Their statement gives investors insight into the Fed
appraisal of the US economy. The statement helps guide investment outlooks as
well as the timing of the Fed’s departure from their historic low interest
rates. The market will be focused on their evaluation of the US employment
situation, inflation, housing, their asset purchase program (QE3), financial
developments they feel are worth noting and finally their voting results from
their committee decision.
The second important economic release occurs this Friday
(2/1/2013) when the US Department of Labor releases their January Employment
Report. This report is important because it gives investors key insight into
the private sector’s demand for labor during this especially nasty debt ceiling
debate. A sustained improvement in the employment report will generate
enthusiasm that the economy is gaining traction. At the same time, it will also
generate questions and doubts about how the Fed will exit the bond market once
the US economic machine starts working again. This is all part of the struggle
between two opposing investment philosophies, one that focuses on preserving
principal and the other motivated by real returns.
William Larkin, Jr.
Portfolio Manager
Happy New Year
January 2, 2013
How did those few hours over the fiscal cliff feel? Did you
wake up with a gasp on Tuesday morning, suffering from that falling feeling?
Instead of toasting the new year, did you pack up all your belongings for an
imminent move to the nearest Hooverville?
Let’s hope you were able to shake your head at the
unproductive games of brinkmanship in Washington, and the hysterics of
financial and other media. “The Cliff” is a dramatic visual image, and I doubt
Ben Bernanke, when he coined the phrase, had any idea it would take on such a
life of its own.
You might not have expected it by watching CNBC in the weeks
leading up to 2013, but “going over the cliff” (which we did) was not an
instant catastrophe. In the same way, “avoiding the cliff” (which we have also
now done) does not solve all economic ills. As usual, the truth is somewhere in
between:
- As far as GDP goes, there was nothing magical about January
first. Any policy changes take time to enact and
to work through the economy.
The precision of a countdown clock is convenient but misleading. The real
difference between Dec 31 and January 1 was passing a proposal on Dec 31
amounted to raising taxes, and
passing the SAME proposal on Jan 1 amounted to
cutting them.
- The stock market had a very good year, with the S&P 500
returning 16% as corporate earnings grew and the
slow recovery continued. Those
sectors hardest hit by the recession – housing, autos, banking – continued to
lead us out. To be sure, it is not all sunshine. Unemployment is still too high
and companies are reluctant to
invest in new equipment. But the S&P is up
2% this morning to start 2013… signaling that Wall Street has
already put the
cliff behind it.
- Longer term government deficits still need to be addressed.
Congress’ inability to tackle the stickiest issues -
entitlements like Social
Security and Medicare- will not please the rating agencies. Our legislators
will remain in
the spotlight as focus shifts from the fiscal cliff to the next
debt ceiling debate, which has already begun.
When you boil it down, not much has changed, has it?
Happy New Year from Cabot.
Craig Goryl
Equity Analyst
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