Market Roundup - April 2012
April showers bring May flowers…or just more rain?
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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Many people probably remember the proverb “April showers bring May flowers.” I recall a version that turned it into a joke: If April showers bring May flowers, what do May flowers bring? Pilgrims! Joking aside, April may be a rainy time for the markets. Although oil prices began to retreat toward the end of March, high prices could pressure corporate profits. Unseasonably warm weather provided some support to the labor market and the construction industry, but with real income growth negative and consumer sentiment sending mixed messages, the market may have run too far and too fast. Regardless of our forecast for rain, we think now is a good opportunity to continue an overweight to equities, albeit with an eye toward longer-term gains in underappreciated consumer staples, health care, and information technology stocks.

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

Brian Jacobsen photo

The economy

By Brian Jacobsen

Most of the U.S. enjoyed an unusually mild winter. In fact, historical detail indicates that the national average temperature for January 2012 was 11.6% higher than the average between 1990-2010. While this could have boosted the construction industry and enticed retail shoppers, it also hurt employment in the travel and tourism industries in states that rely on activities like skiing and snowmobiling. The mild weather in traditionally cold climates also probably kept “snowbirds” from migrating south during the winter. The net effect was likely positive for the construction and retail industries. The effect on the labor market was likely a bit mixed, though likely still positive to the tune of 100,000 extra jobs created during the December to February period. One problem with unseasonably warm weather is that it might not create new economic activity but instead just shift it around a bit. The extra construction and shopping that took place were probably just a shift of activity, not a creation of new activity. This could mean that the March and April data—to be released in April and May, respectively—could reveal some payback.

The Fed

There is a divide in the Federal Reserve (Fed), with three voting members of the Federal Open Market Committee (FOMC) clearly favoring more easing. But there are 10 voting members on the FOMC, so more easing is not a done deal. Operation Twist (see Chart 1), the Fed’s plan to extend the average maturity of its portfolio of securities, is scheduled to wrap up at the end of June. Also, the labor market continues to improve, albeit slowly. In his comments, Fed Chairman Ben Bernanke said he thought the improvement was merely temporary, but a moderate decline in the unemployment rate in March (to be released on April 6) could make it difficult for the Fed to add more easing to the monetary policy mix when it meets at the end of April. Unless there is a reversal of the recent trend, the doves on the FOMC may need to change their feathers.

Sources: Federal Reserve and author’s calculations

Health care reform

From March 26 to March 28, the U.S. Supreme Court heard six hours of arguments related to the health care reform act, which was passed in 2010. The first day’s arguments were about whether the Anti-Injunction Act of 1867 precludes the Supreme Court from hearing the case. Essentially, the Anti-Injunction Act states that the constitutionality of a tax cannot be challenged until the government tries to collect it. Thus, if the penalty for not having health insurance is actually a tax, then its constitutionality cannot be challenged until after 2014 when the individual mandate goes into effect. Although the justices’ questions don’t always intimate how they will decide an issue—since they often try to explore all the different dimensions of an issue, including those they aren’t likely to favor—it seems rather clear that the Supreme Court will find that it does have the ability to rule on the law now instead of waiting until a later date.

The second day’s arguments were the highlight of the hearings and focused on the constitutionality of the individual mandate. Entering the arguments, it seemed as though Justices Scalia, Thomas, and Alito and Chief Justice Roberts would strike down the individual mandate. On the other side, it appeared that Justices Ginsburg, Breyer, Sotomayor, and Kagan would likely uphold the mandate. That left Justice Kennedy as the swing-voter. According to the odds posted on In-Trade (a prediction market), now that the arguments have ended, it looks like Justice Kennedy may swing to the side of striking down the law (see Chart 2).

Source: In-Trade (a prediction market)

If the individual mandate is found to be unconstitutional, then the question becomes whether any part of the health care law can be salvaged. The Supreme Court typically attempts to craft its findings as narrowly as possible, meaning that—when possible—its findings are drafted in a way to uphold laws as much as possible. However, if the Supreme Court finds that the individual mandate is so essential to the law that if it is unconstitutional, then none of the law can stand. At that point, it can say that all 2,700 pages of the health care reform act is without effect.

The public will likely receive the Supreme Court’s decision at the end of June. We believe there will likely be significant changes, regardless of whether the health care reform law is struck down or not. Our preference for investing in health care is motivated by specific industries within that sector that we believe can benefit from growing international opportunities—primarily the biotechnology, pharamaceutical, and life sciences industries.

John Manley photo


By John Manley

“Don’t Fight the Fed” was the first aphorism I learned when I came to Wall Street. After last quarter, I wish that it had been the only one I had learned.

Nothing happened, and that was the key to the market’s success.

In the last 35 years of the 20th century, successful investors learned to follow the lead of the Fed. When the Fed was trying to expand the economy, investors knew to jump on board. When the Fed was trying to slow or contract the economy, investors needed to get out of the way. Falling short-term rates meant higher stock prices, and rising short-term rates would lead to an equity market decline. Earnings growth might mean something for individual companies and groups, but it was liquidity that made the market rise and fall.

Enter the bear markets of 2000–2003 and 2007–2009. The Fed pushed rates dramatically lower, but equities fell just as dramatically, as the Fed’s actions to revive the economy seemed to founder and fail. Consequently, we came to live by the new rules. The Fed could be relied upon to remain accommodative, but that was now a constant and not a driver of incremental equity market returns. The inevitability of “payback” for the excesses of the last 30 years seemed set in stone; the question that would drive the markets up or down was, “When?” Instead of looking to the Fed for guidance, we shifted our gaze toward Greece, Italy, Germany, China, and California. Their crises would be our crises and their reprieves our deliverance.

During the past six months, these two theories merged to form a new mantra for the stock market, one that asserts that the Fed matters again. The market is coming to believe that as the Fed tries to expand the economy, stocks will tend to rise unless some specific crisis emerges from Europe, Asia, or domestically. At a price/earnings (P/E) ratio of slightly more than 13 times the 2012 consensus estimate, the S&P 500 Index is not so much limited by valuation as it is the potential for bad news.

The world is better than it was three months ago, but all is far from fixed. Real problems remain, which could cause real pain if they are not addressed with what may be somewhat painful solutions. However, until those problems devolve into specific crises, it is difficult to determine what could push the equity markets significantly lower. Even then, we think, the risk/reward situation argues for the accumulation of stocks in the months ahead for those investors with a time horizon of beyond 12 months. We also believe that we already know the vast majority of the problems. It is only the discomfort of the solutions that we must still endure.

First-quarter results

Regarding the most recent quarter, the first three months of 2012 brought a 12.6% return (3.3% in March alone) for the S&P 500 Index. The NASDAQ composite (dominated by large-capitalization technology stocks) returned 18.7% in the quarter and 4.2% in March. The Dow Jones Industrial Average (with about a third of its weight centered in energy, consumer staples, health care, and telecommunication services), limped in with “only” an 8.1% return in the first quarter and a 2.0% return in March.

Growth edged out value in March, as the Russell 1000® Growth Index gained 3.0%, while the Russell 2000® Growth Index increased 2.4% in March. Both rose slightly more than 12.0% in the quarter.

The best-performing sector in both March and the quarter was financials, with gains of 7.5% and 22.0%, respectively. The sector’s wild swing is displayed by its 12-month return of -2.2%. We respect the momentum of financials but remain suspicious of its sustainability. We continue to believe that structural issues will weigh on this sector for some time.

Information technology (IT)—a sector that we do favor—was the second-best-performing sector in March. IT rose 5.1% in March, 21.5% in the quarter, and perhaps most tellingly, 19.9% in the past 12 months. We continue to find modest valuations, strong earnings momentum, and solid fundamentals among the large-capitalization IT companies that cater to a business clientele. It has been 12 years since this sector’s mania peaked. We believe a sustainable recovery is under way.
Another sector we like is health care, which showed improved momentum in March. The sector gained 4.4% in the month to beat the market after significantly lagging in January and February. We see a good demographic story and the chance for cash-flow and dividend improvement.

Cyclical sectors generally lagged in March. Energy declined 3.3%, materials rose 0.4%, and industrials gained only 1.2%. Energy was clearly hurt by a slight drop in oil prices (which we believe to be temporary) and a larger decline in natural gas prices (which we believe to be of a more lasting nature). The other two sectors were affected by weakness in Europe and some consequent concerns about first-quarter results.

Overall, we will be interested in first-quarter earnings. We believe that 2012 is a “testing year” for earnings, with ultimately successful results, and that test began in the first quarter.

James Kochan photo


By James Kochan

First-quarter total returns were inversely correlated with credit quality. In terms of credit risk, the further away from Treasuries, the better the returns. The Treasury yield curve steepened during the quarter, with two-year yields rising 8 basis points (100 basis points equals 1.00%) and 30-year yields increasing 35 basis points. A fall-off in foreign demand for Treasuries in February and March was probably the principal reason for the Treasury market correction. From February 1 through quarter-end, the yield on the benchmark 10-year Treasury note increased 40 basis points.

Table 1: Bond market total returns (%)
Market 2009 2010 2011 March YTD
Broad market index 6.12 6.80 7.80 -0.50 0.37

Corporate 19.76 9.52 7.51 -0.59 2.44

Treasury -3.72 5.88 9.79 -1.03 -1.29

Agency 0.90 4.61 5.27 -0.33 -0.02

Mortgage 5.76 5.67 6.14 0.08 0.60

Asset-backed 10.62 5.02 1.43 0.22 0.76

High-yield 56.28 15.24 4.50 -0.09 5.15

Municipal 14.45 2.25 11.19 0.65 2.08

2-year Treasury 1.05 2.28 1.45 -0.03 -0.10

5-year Treasury -1.47 6.76 9.20 -0.67 -0.52

10-year Treasury -9.71 7.90 17.15 -1.97 -2.24

30-year Treasury -25.98 8.65 35.50 -4.54 -7.57

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

Higher coupon income and some narrowing of yield spreads helped the corporate market register considerably better returns than Treasuries. Spreads to Treasuries narrowed 10 to 20 basis points among investment-grade industrials and utilities bonds, while bank spreads narrowed almost 75 basis points. The banking sector recovered strongly in the first quarter, posting a 5.5% total return, versus returns of 1.3% and 0.8% for the industrials and utilities sectors, respectively. As in 2011, the weaker-quality sectors of the investment-grade corporate market performed best. The BBB sector posted a first-quarter return of 3.1%, versus 1.2% for the AA sector. 

The weakest credits also performed best in the high-yield corporate market. While the BB sector recorded a return of 4.1%, the CCC and weaker credits posted a quarterly return of almost 9.0%. All of the first-quarter return in high yield came in January and February as that market continued to recover from the third-quarter sell-off. Over the past six months, the high-yield market has outperformed the Treasury market by more than 1,000 basis points.

The municipal market struggled during March, as new-issue volume began to build and the market prepared for the April tax dates. March and April are often seasonally weak months for the municipal market because new-issue calendars are heavier than in January and February, and withdrawals in tax-exempt mutual funds increase as shareholders make tax payments to the IRS. Yields increased approximately 30 basis points in the 10-year segment of the market last month. For the quarter, returns were uniformly positive but substantially better for the weaker credits. Returns from the A/BBB sectors were 200 basis points better than returns from the AAA/AA sectors.

The pattern of bond market returns for all of 2012 is likely to be similar to that seen in the first quarter. Unless the global markets experience another crisis that revives the safety bid, Treasury yields could rise further in the months ahead. In that event, those markets that still offer generous spreads to Treasuries—high-yield corporates and A/BBB-rated municipals—would be expected to perform best. Sectors such as the mortgage-backed securities market, where spreads are narrower than average, would probably perform only slightly better than Treasuries. Among investment-grade corporates, spreads for bank and finance debt are still exceedingly wide, so those segments would be expected to continue to perform better than industrials and utilities.


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.


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 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  
  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
  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  
  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

Across the globe, several elections and political changes are taking place that merit monitoring. In the U.S., there are risks to the economy if, as under current law, income tax rates, capital gains tax rates, and dividend tax rates increase. Most businesses in the U.S. are treated as “pass-through” entities, meaning that the income of the business is treated as individual income to the owner. These businesses represent more than 54% of all employment and business income in the U.S. When it comes to small business income, over 64% of it accrues to those earning $200,000 or more. Thus, the possibility of increasing taxes on these individuals could be detrimental to economic growth in 2013.

Looking beyond U.S. politics, France will hold an election on April 22. Current poll-leader Francois Hollande has pledged to raise taxes and renegotiate the agreements that have led to the temporary reprieve in the eurozone debt crisis. Greece may also hold a general election in April, which should reveal whether there is popular support for the reforms being implemented.

The eurozone debt crisis could have another flare-up, as Spanish residents protest reforms. Despite missing deficit targets required by the eurozone fiscal compact, the Spanish government has made significant progress toward cutting government spending. The German government has also supported allowing the European Financial Stability Facility (the temporary bailout fund) to run in parallel with the European Stability Mechanism (the permanent funding program), which should give the governments enough firepower to continue pushing problems further into the future, in the hopes that time will heal the problems. Thus, any flare-up in the eurozone should be short-lived.

Meanwhile, Syria and Iran pose greater problems, especially in terms of the possibility of armed conflict. The Syrian government has notionally adopted a proposal from the U.N. representative, Kofi Annan, to work toward peace in the country. A month ago, China and Russia were holdouts in applying pressure to the Syrian government, but their resistance seems to be waning. That still leaves the problems in Iran. The world oil markets have shown to be resilient to the decline in output from Iran, but tensions are mounting as foreign governments continue to impose sanctions on the Iranian government due to Iran’s alleged defiant development of its nuclear program. Considering that Iranian President Mahmoud Ahmadinejad is coming under domestic pressure from Iran’s parliament, the Ayatollah, and the sanctions are beginning to bite, it’s likely there could be a diplomatic, instead of a military, resolution.

While April showers may bring May flowers, it could take a bit longer for those flowers to bloom.

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