Stocks recorded double digit percentage gains for a second consecutive quarter, climbing a wall of worry anchored by the European debt crisis.
Greece defaulted (technically a forced restructuring), and the world didn’t end. Instead, stocks rallied and Spanish and Italian bond yields finished the quarter well below the 7% threshold hit earlier in the year. The debt crisis is far from over, but bold moves by the ECB (primarily in the form of massive loans to banks) assured investors that governments will have more time to solve their problems. Only time will tell if Europe proves to be a solvent union or if the Euro remains in its current form, but the major countries are well positioned to roll debt coming due this year. Therefore, the story should be less impactful on markets in 2012 than it was in 2011.
Iran ratcheted up its saber-rattling this quarter, but only President Obama and Israeli Prime Minister Benjamin Netanyahu have a good idea about the true odds of military conflict in 2012. Oil spiked in early February over the conflict, but retreated later in the quarter. Gold followed a similar pattern, achieving most of its gains in January.
Treasuries declined in the quarter as the US economy continued to show signs of growth. Fed Chairman Ben Bernanke, (who has been exceptionally dour the past few years after being way too optimistic at the outset of the sub-prime crisis) offered a more upbeat assessment in a speech in March. The implications are significant, greatly reducing the chances for any type of “QE3” (additional quantitative monetary easing), and potentially opening the door for the Fed to back away from their promise to hold rates close to zero through 2014 (though nothing explicit was said suggesting such a thing).
Capital Markets Outlook
Volatility in global equities fell sharply from Q4. The daily standard deviation of the S&P 500 dropped from 1.3% in the last quarter of 2011 to to 0.8% in the first quarter of 2012. Smaller fluctuations, coupled with a consistent six month climb, allowed a degree of complacency to creep back into investor mindsets. This means a correction is likely due.
However, attempting to dance around corrections is a poor strategy. Even after two great quarters, very few expect the market to provide significant further upside. The market prefers to act the way the least number of people predict, so in our view this creates the conditions to make big gains probable.
March marked the three year anniversary of the ravaging 2007-2009 bear market’s end. The average lifespan of a bull market since 1932 has been 3.8 years, according to Standard & Poor’s. Usually, this type of analysis would be interesting, but we don’t find it particularly relevant now. It is simply too soon to think this way. Bull markets usually end when sentiment is overwhelmingly positive and everyone wants to own stocks. This isn’t happening now, and we see no reason why the current bull market can’t continue for a long time.
Just as important, the Fed continues to be massively accommodating. Bernanke has pushed short term interest rates close to zero and long term rates close to 3%, and announced he intends to keep them in that range through 2014. Moreover, he has explicitly stated one of his reasons for doing so is to support asset prices such as stocks. Fighting the Fed is a bad idea. Yes, Bernanke recently acknowledged improvements in the economy, but he remains significantly more worried about high unemployment than inflation.
The Bullish Case
- Stocks are cheap globally. The S&P 500 is trading at about 13 times expected 12 month forward earnings, below the historical average. Valuations are not as low as three or six months ago, but they remain attractive.
- Interest rates are extremely low. Historically, valuations of stocks are inversely correlated with rates, implying stocks should move higher. The earnings yield on equities is around 8%, compared to just 2.2% in ten year Treasuries. This is massively bullish if you believe earnings will continue growing.
- The Fed remains accommodating, promising to keep interest rates low through late 2014.
- Almost no one expects large gains in stocks – this is usually a good sign.
- Greece reorganized its debt without contagion into Italy and Spain. Default swaps were honored, reducing concerns about the validity of other outstanding contracts.
- Corporate balance sheets are strong. M&A activity is starting to increase.
- The fourth year of a President’s term has historically been good for stocks.
- The US economy is growing. Unemployment dropped by 0.8% in 2011. Wages are rising.
- The housing market is showing signs of stabilization, though new starts in Q1 fell below estimates.
- Financials stocks are leading the market, a positive sign for lending patterns.
The Bearish Case
- Europe is on the brink of recession and faces increased austerity measures.
- Risk of geopolitical tension stemming from Iran remains elevated.
- Higher oil prices may stifle growth.
- Analyst estimates for Q1 corporate earnings continue to be revised downward.
- Home prices continue to decline.
- China’s property market could be a bubble about to burst, unleashing a wave of bad debt which could slow global growth.
Corporate and Emerging Markets bonds had a solid quarter. Treasuries did not, and lost value. Bonds in general have just experienced a 30+ year bull market. This doesn’t mean a bear market is now imminent, but rates simply can’t go much lower.
Most people don’t understand the extent of the poor after-tax, after-inflation risk versus return profile of many bonds. Many longer duration bonds yielding just a few percent pre-tax, could easily suffer double digit losses if rates rise. Europe should have been the wakeup call. We understand the US is not Greece, and corporate balance sheets are healthy, but there are a lot of potential land mines in the bond market. Fixed income should be an important part of most portfolios, but we believe it must be approached with as much care as stocks.
The US economy continues to show signs of improvement. While unemployment remains elevated at 8.3%, jobless claims have trended down and now sit at a four year low. Most US housing data came in better than expected, with strong year over year existing homes sales and falling inventories. Building permits and housing starts were up sharply over 2011. Prices continued to fall, but recent data shows the rate of decline is slowing.
Corporations also show signs of improving health. Over the last three months approximately two-thirds of companies in the S&P 500 reported earnings ahead of consensus expectations. Technology, Industrials, and Energy experienced the highest growth, while Telecommunications and Basic Materials came in on the low end.
The US Commerce Department issued its revised 2011 fourth quarter GDP growth estimate, unchanged at +3.0%. Many believe there is a disconnect between this modest rate and the much more rapid fall in unemployment. But perhaps the discrepancy can be reconciled by stronger GDI readings (gross domestic income), which came in at +3.0% and +4.4% in the third and fourth quarter, respectively. GDI measures the amount of income received in the economy, rather than the value of goods and services produced. These rates are more consistent with the improving labor market.
Looking ahead, consensus calls for relatively modest economic growth, and we tend to agree. While the impact thus far has been minimal, a slowdown in China, a recession in Europe, and higher oil prices will weigh on US corporations. But in aggregate there are still many positives. US businesses are extremely healthy boasting cash rich balance sheets. This should drive new expansion projects and bolster job growth, or even fuel another period of M&A. Any improvements in the housing markets would provide a significant tailwind to the economy.
All of this means the US economy is likely to continue on its bumpy path of improvement. It has been an unusually slow recovery, but we must keep in mind the preceding downturn was equally unusual.
Thematic Shifts – The New Major Trends
A small number of major themes dominated the global economy over the last decade or so. Among them:
- The dot-com bubble, collapse, and rebirth.
- Massive growth in China (fueled largely by US and European spending), and the ensuing materials boom.
- The rise of the Euro, and possibly its peak.
- The US housing market bubble, collapse, and the ensuing financial crisis.
- Global interest rate declines, government spending increases, and sovereign default risk.
In markets, the normal pattern is expansion, peak, contraction (or collapse), trough, repeat. Each of the trends listed above is in a phase of this cycle. Some have played out and no longer feel that interesting. But some are shifting into a new phase and will be quite impactful in coming years.
China was perhaps the most important theme of the last decade. The country’s emergence onto the world stage and its impact on global GDP growth has been mind-blowing. The nation’s massive infrastructure build-out almost single handedly fueled a decade long boom in commodities. The benefits trickled down to emerging and developed markets alike as materials producers profited from higher prices. This government spending spree also created a burgeoning middle class, driving demand for automobiles, televisions, cell phones, and perhaps more importantly, real estate.
Recent data suggests this prolonged period of rapid expansion could be coming to an end. In the last few months we’ve seen slowing GDP growth, fixed asset investment, and retail sales. Not to mention a sizeable real estate slowdown—an event likely to drive a surge in loan defaults.
The nation’s manufacturing boom has driven rising labor costs and increasing worker demands. Headlines surrounding poor conditions at a supplier for Apple brought additional attention to the issue. China is losing its long-held comparative advantage in low cost labor. Other countries will pick up some slack, but in all likelihood this will bring more manufacturing jobs back to the United States. Lower energy costs in the US, coupled with improving automation technology, are making it easier to compete with armies of lowly paid Chinese employees.
China will continue to become more important on the world stage, especially politically, but its age of rapid, easy growth could end more swiftly than most imagine.
Demonstrations in the streets of Athens, Lisbon, Rome and Madrid paint a vivid picture. Despite recent steps by the ECB to calm the situation, the Eurozone is in trouble. The Euro rose steadily from 2002 until 2008, peaking at about $1.60. Interestingly, the arrival of the US sub-prime crisis marked the top. It now sits around $1.30. Why did a mostly US problem cause the Euro to fall? Because the increased spotlight on debt markets revealed that not only were many European banks overexposed to bad debt, many European governments were running unsustainable deficits.
The situation varies largely by country, but Europe as a whole is on the brink of recession and faces serious challenges. Austerity measures are likely to make things worse. The Euro is based on a complicated structure and a central bank not intended to print money, limiting policy choices. Europe feels like it remains in the contraction phase of the economic cycle.
The United States
Two of the themes in our list tie directly to the US. They share a nice feature – in or rapidly approaching the recovery phase.
Whatever the flaws of the US, it remains the dominant innovator of new technologies. Being in Silicon Valley, we can’t help notice that there are a lot of exciting new developments creating a lot of new wealth. The current tech boom won’t reach the frenzy of the late 1990’s, but that is actually a good thing. This trend should gain momentum for some time to come.
The housing cycle is even more important. Housing prices probably have not bottomed, but they appear close. Residential construction has entered expansion and there are signs of new commercial building as well. The benefits of a recovery in construction and an eventual increase in home prices could be enormous.
A potential new theme, “energy independence” is becoming more than a theoretical notion tossed around by Presidential candidates. The emergence of hydraulic fracturing (“fracking”) has unlocked vast amounts of natural gas in the US. Natural gas prices have plummeted over 80% since the peak in 2006. The benefits are clear. Natural gas is cleaner burning. Domestic production will become cheaper and more efficient for many manufacturers. Coupled with increasing domestic oil production, it will reduce reliance on imports. Total US energy independence has quickly become a very real possibility. Cheaper energy will drive manufacturing gains (often at the expense of China).
Additionally, if the US stops exporting billions of dollars to buy energy, there will be a lot less dollars floating around the rest of the world. Simple supply and demand should provide a boost to the dollar relative to most major currencies.
What’s the bottom line? An increasingly likely driver for the next decade could be the resurgence of the United States of America and the U.S. Dollar.
Note: Much of this is largely theoretical, and far from certain. The reality is the US debt picture is not much better than Europe’s, other than having a more powerful central bank. But our central bank has been printing money with gusto – not exactly consistent with a strengthening currency or a strong economy. We continue to believe global diversification is critical for successful long-term investing.
Bill Harris, Craig Birk, Rob Foregger and Kyle Ryan
The Personal Capital Advisors Investment Committee
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