Market Roundup - June 2012

A menu of market volatility

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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There was little good news in May for the market, which was reflected in the S&P 500 Index dropping like a rock and the yield on the 10-year Treasury falling to historic lows. There was some good news for homeowners and drivers, as mortgage rates fell to historic lows and oil prices dropped below $90 a barrel. However, pointing to low rates and lower oil prices as positives feels a little disingenuous to us. Let’s face it, the economy of 2012 is looking a great deal like the economy of 2010, with a decent winter, a bad spring, and an uncertain summer.

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

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The economy

By Brian Jacobsen

Looking at the calendar for possible events in June, we thought it would be helpful to discuss what we believe could be the three biggest market-moving events: the health care reform ruling, the elections in Greece, and the Federal Open Market Committee meeting.

The Supreme Court is likely to issue its ruling on whether the Affordable Care Act (ACA), or parts of it, is unconstitutional. If history is any guide, the Supreme Court will release its ruling on a Monday in June. Given the controversy surrounding the ACA, the Supreme Court justices may be working diligently late into the nights and late into the month on this ruling. The justices have already made up their minds. In fact, they voted on the ruling shortly after the arguments were made in March, but now they’re in the process of drafting the opinion, which can be a time-consuming process.

Whether or not the ACA is found to be unconstitutional, we think health care stocks are attractively priced. Valuations, based on forecasted earnings, have recovered since the ACA was signed into law on March 23, 2010. However, analysts’ expectations of the long-term growth rate of earnings have not recovered. That could turn health care stocks into mispriced growth stocks, especially considering that the population in the U.S. continues to age and there are growing opportunities for U.S. health care companies to export to the emerging markets.

The significant global event for the month will likely be the June 17 elections in Greece. In May, the Greek elections resulted in a fractionated parliament, and a government couldn’t be formed. The top three parties—New Democracy, Syriza, and Pasok—were unable to reconcile their differences to get a majority of their members to elect a prime minister. As a result, voters must go back to the polls to give it another try.

The Syriza party is made up of communist and other left-leaning parties that want to renegotiate the bailout details. While it appears as if the people want to keep the euro and stay in the eurozone, a significant number of them want a better deal. Based on statements from other eurozone leaders, like Chancellor Angela Merkel in Germany, European Central Bank President Mario Draghi, and French Prime Minister Francois Hollande, Greece may negotiate a slightly better deal and be able to postpone some of the spending cuts and tax increases for a year or more.

The New Democracy party may get a larger percentage of the popular vote, which could allow the party to form a government without the cooperation of Syriza. That would be a decidedly positive step for the eurozone.

The third major event for June could be the Federal Open Market Committee (FOMC) meeting on June 19 and June 20. The FOMC has done much to prop up the markets, with even a hint at further easing seeming to push bond yields lower and stocks higher. In late November 2008, the Federal Reserve (Fed) began buying large quantities of mortgage-backed securities (quantitative easing, or QE1). Effectively, in an environment where investors were shunning credit risk, the Fed stepped in to take credit risk onto its balance sheet. In November 2010, the Fed began buying large quantities of Treasury securities (QE2). At that time, investors seemed to fear an imminent rise in yields, so the Fed took that interest-rate risk onto its books.

In September 2011, the Fed announced Operation Twist, where it shifted the composition of its Treasury portfolio to longer-dated securities, taking even more interest-rate risk onto its balance sheet. At the end of June, the maturity extension of its balance sheet will be completed, so investors will be looking at whether the Fed has any more tricks up its sleeve. Although the Fed could do more (there’s always more a policymaker could do), we don’t think the Fed should do more. The economy isn’t faltering for a lack of monetary stimulus or because interest rates are too high. Right now, it looks like the onus needs to fall on Congress and the president to avoid what we have called the “tax wall,” or what Federal Reserve Chairman Ben Bernanke has called the “fiscal cliff.” Under current law, tax rates are scheduled to rise dramatically, effectively shaving three percentage points of growth off the economy in 2013 by our estimates. Not only does this tax wall threaten growth in 2013, it has also likely been holding back hiring throughout 2012. That is an issue that is not likely to be resolved until November.

John Manley photo


By John Manley

Last month, the equity market sent out an extremely real and extremely loud international distress call. After more than six months of expecting bad news and getting none, the market was hit with a veritable deluge in May. Those who thought our problems were behind us were surprised by how ineffective democracies could be in fighting deflation and how fragile and ephemeral bank earnings and bank balance sheets could be. The risk-off trade was back with a vengeance, and the possibility that it could become worse seemed to loom before us yet again.

Stock markets surged earlier this year in response to a combination of low valuations, solid earnings momentum, deep investor skepticism, and strong Federal Reserve monetary pressure. Prior to that rally, equities had been priced for a continual stream of “unexpected” problems (black swans). The emergence of a host of grave possibilities was viewed as only a question of time. When these events did not occur, investors became skeptical of the skeptics and began to mentally push the “due date” for disaster into the indefinite future.

Now those problems are in the forefront of investors’ consciousness. Thus, we believe it is time to reiterate our thesis that, over the course of 2012, the S&P Composite Index will remain in a trading range of 1,250 to 1,450. While the actual numbers are not carved in stone, the argument behind them is quite simple: It is too soon for the market to either rise or fall dramatically.

First, we believe it is too soon for the market to rise dramatically because nothing is completely fixed. There are still numerous promises in the world that simply cannot be fulfilled. Debt levels are unsustainably high and moves to restrain them, in our opinion, will require that the markets (“stock vigilantes”) act as a nanny to force the issue.

Second, we believe there are a number of reasons why it is too soon for the markets to fall dramatically. While all problems are not fully discounted, they are anticipated in some form or another. Valuations already reflect significant skepticism toward the possibility of continued earnings growth. More to the point, we believe there are still a number of tools available to decision-makers to postpone Armageddon. These may be only palliatives, but given current investor attitudes, feeling better may be enough to sustain us until more lasting solutions are found.

Despite a terrible showing, the S&P 500 Index’s performance in May was actually better than most international and domestic equity indexes. The S&P 500 Index fell 6.3%, while the CAC 40 (France), the DAX (Germany), and the FTSE 100 (U.K.) declined 6.1%, 7.3%, and 7.3%, respectively. These comparisons, along with a strong U.S. dollar in the period, indicate that the U.S. was viewed as a bit of a safe haven in the storm.

Other U.S. indexes also fared more poorly than the S&P 500 Index. The Nasdaq Composite, heavily weighted with technology, fell 7.2%. Even the solid Dow Jones Industrial Average was off 6.2%. The Russell 3000® Growth Index and the Russell 3000 Value Index slipped 6.7% and 6.2%, respectively. Small-cap stocks generally lagged, with both Value Line Indexes down more than 7.5%.

Sector returns generally rewarded yield and punished cyclicality and leverage. The best performers were the higher-yielding sectors, such as telecommunication services and utilities (2.6% and -0.1%, respectively). We have been neutral on both sectors. The worst performers were energy and financials (-10.6% and -9.3%, respectively). We continue to like the energy sector for its large-capitalization names and exposure to spending on more plentiful natural gas. We remain underweight in financials on concerns about leverage and regulation. Two of the sectors we favor, consumer staples and health care, also declined (-1.3% and -3.9%, respectively) but still outperformed those sectors that are highly cyclical.

In April, we wrote about a correction that could be nasty, brutish, and short. Certainly, the first two of those adjectives could be applied to the equity market’s behavior in May. We hope that the third will also be fulfilled.

James Kochan photo


By James Kochan

The crisis in Europe was the dominant influence on the U.S. bond markets in May. Another flight to safety by global investors pushed yields on Treasury notes and bonds to record lows late in the month and produced strong returns on the 10- to 30-year maturities. The yield curve flattened 50 basis points in the month, not because of the Fed’s Operation Twist, but because the Treasury market is the prime beneficiary of chaos overseas.

Table 1: Bond market total returns (%)
Market 2009 2010 2011 May YTD
Broad market index 6.12 6.80 7.80 0.96 2.49

Corporate 19.76 9.52 7.51 0.58 4.35

Treasury -3.72 5.88 9.79 1.83 2.05

Agency 0.90 4.61 5.27 0.61 1.35

Mortgage 5.76 5.67 6.14 0.33 1.62

Asset-backed 10.62 5.02 1.43 0.25 1.26

High-yield 56.28 15.24 4.50 -1.21 4.94

Municipal 14.45 2.25 11.19 0.93 4.17

2-year Treasury 1.05 2.28 1.45 0.01 0.08

5-year Treasury -1.47 6.76 9.20 0.84 1.61

10-year Treasury -9.71 7.90 17.15 3.46 4.06

30-year Treasury -25.98 8.65 35.50 9.26 5.85

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

As usual, the risk-off trade was most damaging to the corporate market. The high-yield market showed again that it is correlated with equities, not Treasuries. Monthly returns ranged from -0.6% for the BB credits to -2.4% for the CCC and weaker segment. The year-to-date (YTD) returns are now 7.2% for the CCC index, and 4.3% and 4.7% for the B- and BB-rated credits, respectively. Among investment-grade corporates, the banking sector was the worst performer in May, with a total return of -0.40%. Year to date, however, that sector has returned 5.8%. Among quality grades, the BBB segment recorded a total return of 0.4% in May, versus returns of 0.6% and 0.9% for the A and AA credits, respectively. However, YTD returns are 4.9% for the BBB index versus 4.2% and 3.5% for the A and AA indexes. Even after an extreme flight from risk in May, the higher-yielding segments of the corporate markets have produced the best YTD returns.

While not entirely immune from the European crisis, the municipal market responded primarily to continued healthy inflows to the tax-exempt mutual funds during May. Apparently, a significant share of the balances that were withdrawn from equity funds has gone into municipal funds. Unlike the patterns seen in the corporate market, the A- and BBB-quality municipals continued to perform better than the AAA/AA segments. In May, the A/BBB segments produced a return of 1.1%, versus a return of 0.75% for the AAA/AA sectors. Thus far in 2012, the A/BBB credits have outperformed the AAA/AA credits by 300 basis points. Because municipal yield curves remain unusually steep, the 10+-year maturities have outperformed the one- to three-year maturities by 500 basis points thus far in 2012.

While the problems in Europe appear sufficiently intractable to keep Treasury yields exceptionally low for the foreseeable future, it is worth noting that a crisis involving a default by Greece pushed the 10-year yield to 1.70% last September. Only a month later, that yield was 2.40% after the European Central Bank (ECB) acted to prevent a severe banking crisis. Whenever markets become significantly overbought, even a modest amount of good news can prompt a major correction. The April/May rally in Treasuries might have created market conditions that can persist only as long as the European markets are in disarray. If market conditions in Europe are untenable, so, too, are the record-low Treasury yields.

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 information technology (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

At the beginning of the year, we titled our 2012 outlook “We’re all emerging markets.” That seems even truer now than it did then. As we explained, the reason is that emerging markets typically trade at a discount to developed markets because of the political risks posed by emerging markets. All markets seem to be dominated by politics now, and that doesn’t look like it will change in the near term.


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