Posted on July 10, 2012
Stock market returns were looking pretty dismal coming into the final few trading days of the second quarter; but, the European Union Summit, the 19th such meeting in the past three years, provided some early 4th of July fireworks. The last trading day of the quarter saw domestic large capitalization stocks (S&P 500) rise 2.5%, domestic small-cap stocks increase 2.9%, emerging market stocks advance 3.4%, and developed international stocks surge 3.6%. Overall, the last trading day of the quarter saw global equity markets up 3.1%, and global bond markets up more than 0.5%. Wow, when have we seen such a massive move in global markets over such a short period of time? Oh yeah, the last week of June 2011, on the heels of another EU Summit proclamation to do “whatever is necessary” to stabilize the euro, saw global markets rise 4.2%. Einstein described doing the same thing over and over again and expecting a different outcome as the definition of insanity. When will investors figure out that this is precisely what the European Union has been doing over the past 19 summits and that these gains won’t stick without actions to back those words?—over the past 12 months, including Friday’s big move, global equity markets are down 6%.
Even with the end of June rally, it was a tough quarter for investors, with very few asset classes offering positive returns. The S&P 500 was down 2.8% for the quarter, domestic small-cap stocks were down 3.5%, developed country international stocks were down 6.9% and emerging market stocks were down 8.8%. Bonds fared much better as domestic investment grade taxable bonds returned 1.6%, high yield bonds returned 1.8% and tax-exempt bonds returned 1.1%; but, international taxable bonds were down 0.4% in large part because of the 4% rise in the value of the US dollar during the quarter. The dollar’s increase in value relative to other major currencies also contributed to the 8% decline in commodity prices, and in particular the nearly 20% decline in crude oil prices.
Our clients’ portfolios held up reasonably well in this difficult environment primarily because of our emphasis on diversification and our focus on income generation. Specifically, we have roughly 30% of our domestic large cap equity exposure allocated to a couple high dividend yielding exchange traded funds—those funds perform much better, on a relative basis, than the broad market when equity valuations are declining. In addition, our decision last fall to reduce exposure to energy infrastructure and increase exposure to commercial REITs based on our relative value analysis continues to pay dividends (pun intended) as the commercial REIT market was actually up 3.8% during the quarter. But the star performer once again was our Opportunistic sleeve, as it posted a positive 2% return for the quarter. The sleeve is designed to capture non-traditional income streams from varied asset classes such as senior bank loans, preferred stocks, convertible bonds and mortgage REITs, while simultaneously hedging away equity-like market risk inherent in each of those asset classes. Through the first half of the year the sleeve is up nearly 9%.
As one likely surmised from the first paragraph, we aren’t quite prepared to declare an end to the European sovereign debt crisis. Certainly enough progress was made to prompt a huge short-covering rally in the markets; but, as was the case last year, we believe this rally will likely be short-lived. The European sovereign debt crisis will not get solved with promises and proclamations but rather with actions. The periphery nations in the Eurozone face significant challenges: low to negative growth, high unemployment and huge debts with rising costs of funding those debts. Of these challenges, this most recent summit only attempted to address the cost of funding the debt. That said, if there is timely follow through with some of the summit’s agreements it will go a long way toward stabilizing European banks, and thus preventing any contagion from spreading to our shores.
Obviously equity prices are lower today than they were at the end of the first quarter, but earnings guidance has also been lowered. Economic conditions across the globe have weakened in the past three months. The so-called “best run” domestic bank had a $9 billion trading error (which they initially characterized as a tempest in a teapot and then sized up as a $2 billion loss) and the “best run” European bank just admitted to price fixing the LIBOR rate (and by definition they couldn’t have “colluded” on their own—other large European banks were likely in on it)—two acts that will most certainly lead to more regulations both here and abroad. On the positive front, lower energy prices will provide much needed relief for domestic consumers, ever-declining interest rates will eventually force investors, in particular pension plans, to reallocate assets to equities, and central banks across the globe are poised to provide additional stimulus should it be needed.
On balance, we continue to think market conditions warrant a more defensive posture. We used some of the market strength in June to reduce clients’ equity exposure by roughly 15% (e.g. if the target equity weighting was 40% it is now 34%). For the time being we are holding the proceeds of those sales in cash until we see a more attractive opportunity. We remain committed to our mandate to build the least risky portfolios necessary for our clients to achieve their financial goals.
Disclaimer and Disclosures
This report is provided for informational purposes only, and does not constitute any offer or solicitation to buy or sell any security discussed herein. All opinions expressed and data provided herein are subject to change without notice. All investments involve different degrees of risk. You should be aware of your risk tolerance level and financial situations at all times. Past performance does not guarantee future results.
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