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Wednesday, March 7, 2012
Editor's Corner
Market Pullback Feels Worse Than It Is
Ron Rowland
Anyone who has worked on Wall Street knows investors have short memories. People expect today will be like yesterday, and tomorrow will be like today. To some extent they are correct. That’s why “momentum” is a useful indicator. Nevertheless, even the best trends falter at times.
Such has been the case since last Friday. Having moved upward almost without interruption since mid-December, U.S. stocks stumbled. How badly? Over three days, the S&P 500 dropped only 2.2%. This hardly seems to justify some of the breathless commentary we heard. The situation could always worsen, of course, but the bigger issue is investors forgetting what “volatility” looks like when they go ten weeks without seeing it.
Market chatter is once again focused on Federal Reserve action. Today the Wall Street Journal reported a new Fed plan is in the works to keep long-term interest rates low without sparking inflation via “sterilized” bond-buying. Exactly how this would work, or why it is even necessary, is unclear so far. Perhaps we will learn more after next week’s Fed policy meeting.
For now, ten-year Treasury yields are still stuck in a tight range around 2%. Gold prices pulled back along with crude oil and other commodities. Gold bullion is trying to find support around its 200-day moving average.
Economic news is still mixed, with data points available to support whatever view you prefer. Friday’s jobs report is expected to show 210,000 new jobs created in February and the unemployment rate steady at 8.3%. If the forecasts are correct, recovery is still proceeding at a frustratingly slow pace.
Sectors
Technology was big news today as Apple (AAPL) unveiled the iPad 3, along with some other goodies, at an event in San Francisco. Less noticeable was Monday’s new all-time high for IBM. Both stocks helped the tech sector stay on top of our chart. Consumer Discretionary is just behind, followed by Financials. We are starting to see early signs of weakening in the banking segment. Fourth-place Energy lost a lot of momentum since last week and is now tightly bunched with three other sectors just below. This could lead to a big shake-up by next week. Health Care and Consumer Staples improved a bit, helped by short-term investor nervousness. Materials had a very bad week with its momentum score tumbling from 32 to only 9. Telecom moved down a peg, and Utilities stayed in last place.
Styles
The Style rankings look nothing like they did last week. This is unusual; major shifts typically show up in the Sector chart first and then have a more gradual impact on the Style categories. The current shift is driven by significant underperformance in small cap stocks. Over the last twelve market days, the Russell 2000 Index dropped 5.1% vs a 1.4% decline for the S&P 500. Micro Caps took a 5.5% hit in the same period. Hence we have Mega Cap moving up from sixth place a week ago to the top spot now. Large Cap Growth is in second place followed by Mid Cap Growth. Small Cap Growth - last week’s leader - fell all the way to #8 in relative strength. We still see a preference for Growth over Value regardless of size.
Global
U.S. stocks took the top global spot despite losing momentum, as markets everywhere else lost even more. Emerging Markets slipped into second place as the U.S. benchmark climbed from fifth to first. Latin America finds itself in the #3 spot. Japan, now in fourth place, was near the bottom only a month ago. Much of the credit goes to a declining Yen, which makes Japan’s exports cheaper for foreign buyers. China plunged to tenth place as the government there reduced economic growth objectives. Reduced Chinese demand for raw materials had an impact on resource-heavy Pacific ex-Japan and Canada, which are now among the bottom of the list.
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barringtonfinancial.com commentary
STRATEGIC OVERVIEW
March, 2012
SHORT TERM VIBRATION:
Stocks continued grinding higher in February as the rally of 2012 now has the S&P 500 sitting on 9% gains. Amid all the bullish activity, there are signs that the pullback most investors want may be approaching.
One such sign is the shift in leadership among equities. Small-cap stocks, which tend to perform better during market rallies, have underperformed. As investors continue to assume more risk, riskier small caps should outperform the large caps. However, the past four weeks has seen the Russell 2000 up an anemic 0.69% while the S&P 500 is up more than 3%
Key divergences such as this illustrate a possible correction on the horizon. Additionally, the S&P 500 is bumping against key resistance levels. It now becomes a waiting game to see if stocks merely consolidate or correct significantly from their lofty perches.
Exposure to equities should be reduced at this time allowing markets to digest gains and establish either a continued uptrend or offer up a correction. A pullback in stocks would offer patient investors better entry prices.
Bonds and fixed income assets remain inflated at current levels. It appears a near term top occurred in municipal bonds two weeks ago after President Obama unveiled an initiative to remove tax shelters from these investments for individuals that meet a certain income level.
On the corporate side, investment grade debt is still being held in high regard by most investors as A-rated bonds continue to command high prices with yields less than 3% for most short term notes with maturities of 5 years or less.
Due to the lack of debt yields, those scavenging for gains are forced to go down the food chain and begin loading up on lower grade corporate bonds offering higher risk of default, aka junk bonds. The past several weeks saw the average yield on junk bonds ease from already historically low levels (approximately 7.35%) as desperate investors paid up for investments offering higher coupons. Junk bonds could provide a little more upside as the yield chasers keep buying these investments not because they want them, but rather because there are so little options available to them.
Medium term:
Even though equities could see a correction in coming days, the medium term trend for stocks remains positive. Although equities are becoming less attractive fundamentally, the dearth of investment returns available in other asset classes, such as bonds and fixed income, force even the most risk averse investor into equities in an effort to generate returns.
Thus, "invest in equities by default" becomes the new investment strategy theme for most money managers seeking asset appreciation in portfolios. This is not exactly the most reassuring reason to invest in a specific asset class which is why caution continues to be at the forefront of our investment strategy. Although stocks are not as inflated as the bond or fixed income markets, this disparity does not automatically qualify equities as being the best place to put money to work.
Not much has changed in the near term. There continues to be a lack of value in nearly all assets. Much of this "investment inflation" is the result of the loose monetary policy being employed in the U.S. and Europe. Government intervention allows both the European and U.S. markets to gain steam in the early part of 2012. Most assets from bonds to stocks already factored in the latest rumblings from the Fed regarding no interest rate hikes until 2014.
If this is true, the validity of a majority of the data coming out of the media suggesting the U.S. economy is finally on the mend becomes suspect. After all, it is an election year.
Also, the greenback is not weakening as sharply as it has in the past as the Fed keeps printing money and artificially presses interest rates lower. In fact, the dollar appears to be in a longer term bullish trend. If the dollar does not crack in the near term, it may be telegraphing that policymakers could surprise investors and the markets with an early rate increase. Initially, this hawkish monetary policy would shock bond, gold, and equity markets.
Finally, the dramatic rise in oil prices merits watching. The last time oil outperformed the markets in such dramatic fashion the U.S. economy slipped into recession soon after and stocks took a haircut. Additionally, the Economic Cycle Research Institute (ECRI) continues to maintain its recession call for the U.S. economy. The ECRI is one of the most recognized sources for economic and market data. According to the institute, its indicators suggest there is no way the U.S. avoids a recession in the coming months.
With all these mixed signals being presented to investors, it continues to be a challenging market. There is a good possibility the markets may offer more gains throughout 2012, but to employ a buy and hold strategy at this late stage of a four year bull market cycle presents a risk/reward ratio that appears unfavorable based on the timing of it. In the event the U.S. encounters another recession, it almost assures investors cheaper prices and better values everywhere from stocks to bonds.
EXECUTIVE SUMMARY:
Current market conditions suggest all is right with the stock market and equities are now the place to invest. Although the argument can be made that stocks are not as overpriced as other assets, it would be folly to think that they are immune from a healthy correction in the near term after such a solid move the past several weeks.
A majority of our clients are showing gains of 2%-5% in their portfolios since Jan. 1. Although this trails the overall market by a few basis points, most accounts are still underweight equities and in a majority of cash. The level of caution is in accordance with the lack of value being seen in all investment assets.
After this recent rally, many equities sport prices where it becomes difficult to take a long term position. The recent economic data indicating a near term peak being seen in the Purchasing Managers Index also should temper even the most bullish investor.
The Purchasing Managers Index (PMI) is a composite index of five "sub-indicators" extracted through surveys to more than 400 purchasing managers from around the country.
PMI is an important sentiment reading, not only for manufacturing, but also the economy as a whole. Although U.S. manufacturing is not the huge component of total gross domestic product (GDP) that it once was, this industry is still where recessions tend to begin and end. For this reason, the PMI is very closely watched, setting the tone for the upcoming month and other indicator releases.
The magic number for the PMI is 50. A reading of 50 or higher generally indicates that the industry is expanding. If manufacturing is expanding, the general economy should be doing likewise. Another useful figure to remember is 42. An index level higher than 42%, over time, is considered the benchmark for economic (GDP) expansion. The different levels between 42 and 50 speak to the strength of that expansion. If the number falls below 42%, recession could be just around the corner.
As with many other indicators, the rate of change from month to month is vital. A reading of 51 (expanding manufacturing industry) coming after a month with a reading of 56 would not be seen favorably by the markets, especially if the economy had been showing solid growth previously.
Viewed at the global level, the manufacturing PMI index softened slightly from 51.3 to 51.1 this past month. This was the first decline in three months. Thus, a peak is anticipated in the spring. This could be followed by a mild economic slowdown. Growth momentum is anticipated to pick up near the end of the year.
The softening in February PMIs is more visible in developed countries. In the US, the February ISM Manufacturing index took a breather after rising to the highest level since June 2011 last month. The headline index declined from 54.1 to 52.4 in January. This was the first easing in four months, which indicates potential slowing ahead. The possible economic slowdown may not be factored into the price of stocks.
Because of the risk this recent economic data suggests, our outlook remains cautious. Currently, the estimated asset breakdown in the model client portfolio reflects this:
12-15% equity
20% macroeconomic bond exposure
15% fixed income/bond
47-50% cash
If stocks begin to reflect better valuations following a healthy correction and the U.S. economy continues to reflect only a mild slowdown, we could become more constructive on equities adding to our small positions and attempting to take advantage of any further upside in the stock market. Most bond and fixed income areas are inflated forcing us to remain selective and patient. We are focused on only those debt issues just below investment grade that may offer companies with sound balance sheets and bonds pricing under par with size-able annual yields greater than 7%.
We continue to monitor the markets, and maintain a defensive position in anticipation of a larger correction. We try to emphasize the need for us to be cautious at this time, which is why maintain a large cash position, with diversified exposure to equities and fixed income investments that we feel are less volatile and provide yields and dividends in an uncertain market.
If you have any question about strategy or investments, please feel free to contact us anytime by phone or email. 713-785-7100 or [email protected]