First Quarter 2011 Market Update Letter
“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to Heaven, we were all going direct the other way- in short, the period was so far like the present period, that some of its noisiest authorities insisted on its being received, for good or for evil, in the superlative degree of comparison only”
Tale of Two Cities by Charles Dickens
“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to Heaven, we were all going direct the other way- in short, the period was so far like the present period, that some of its noisiest authorities insisted on its being received, for good or for evil, in the superlative degree of comparison only”
Tale of Two Cities by Charles Dickens
We are constantly hearing from the talking heads and politicians that alternatively the world is ending or every thing is going to be just fine. We feel the answer lies somewhere in the middle so our job is to be alert to how the markets discern the risks we face. The markets continued to be volatile as we moved through the first quarter; although, its direction was up. Our focus, as always, continues to be on risk management and, to the extent possible, the avoidance of market extremes. For the balance of the year, our focus will be on the overall performance of our economy and the world economy and attempting to select the right vehicles to maximize return and minimize risk in this environment. At the same time, we want to try to take advantage of any direction that the market chooses to take.
End of Quantitative Easing (“QE”): Perception vs. Reality
We are not particularly worried about how the markets will react to the end of QE. It might not be good – even if you believe the impact from QE has been limited. However, we do not think it will be as bad as many fear and we are careful not to use the period post QE1 as the benchmark given that it also corresponded with a flare-up in European sovereign debt concerns. We think the economy can (for now) stand on its own without the need for extraordinary liquidity measures, and if growth data holds then markets will remain supported even if there is a negative sentiment impact.
There are a number of problems with assessing a post QE world for risk assets. Not only is it difficult to determine/disentangle what the impact has been on risk assets and the economy, but also how investors will react over the coming months: will they move pre emptively to de-risk? Will they take profits from equities? How will growth data hold? Will the world still be confronted with $120/bbl oil? The end of QE will not occur in a vacuum.
Our best guess? At a minimum, it removes a backstop for risk assets. We are not bullish on growth, rather our view is that growth is not at risk of collapsing as the Fed unwinds its balance sheet. Over the medium term, we worry about the structural issues which are pushing the government to get fairly serious about addressing its fiscal position (or else money printing might unfortunately prove the only solution) However, for now we think if growth data holds then markets will remain supported even if there is a negative sentiment impact.
We would make the following points:
• Positive correlation between Fed purchase and equities is not a causation: We think the measure of QE’s success is whether the recovery becomes self-sustaining – we think it is, with an improving labor market the key, going forward. It seems obvious that the correlation between equities and Fed purchases of asset backed securities and US Treasuries since the start of QE has been positive. But, the Fed was also expanding its balance sheet through the financial crisis and the correlation with equities was negative during this period. The correlation with Leading Economic Indicators (i.e. ISM) has also been positive and while it has been more volatile, so has the correlation with indicators such as payrolls. The point we are making is that correlations with Fed purchases and selected economic indicators are all positive – but correlation is not causation.
• Consensus growth estimates for the US rising: We are not the first to admit that the US recovery might not look great. There is enough ammunition for the bears to use to discredit the success of QE. Credit creation remains weak, the housing market is once again deteriorating and income growth has been non-existent (a wage-less and job-less recovery). But equally, we can point towards a significant rebound in manufacturing, strong Purchasing Managers Indexes, improving labor market and an equity market which has doubled over the same period. We know that US is still not in great shape and that a multi-trillion dollar expansion in the Fed’s balance sheet should have done more. But growth looks a little more like the “old” than the “new” normal at least for the next two years if consensus economics forecasts are to be believed (2.9% in 2011 and 3.3% in 2012).
• Policy normalization likely to correspond with a small correction: Our biggest concern is that there will be a sentiment impact on markets as QE unwinds. We are already seeing higher bond yields and a flatter yield curve as the market anticipates the next phase of policy normalization. But for all the rhetoric around market impacts, we are yet to see signs of sector rotation of significant outflows. For markets, a simple analogy could be historic performance around rate hikes which has traditionally corresponded with a period of indigestion, and a small correction.
• QE unwinding unlikely to be the sole catalyst for market correction: Overall, we think it is unlikely that QE will be the catalyst for a correction in markets on its own. We remain more concerned that it may correspond with a peak in growth data momentum, still elevated oil prices and a weakening earnings backdrop. Irrespective of whether QE has been the key driver of the rally in equities or not, the strongest performers have been the risk on trades – small caps (back above their 2008 high), commodities and value over growth (the former dominated by Financials).
To that end, we believe that it makes sense to be long high quality, defensive, dividend yielding and dividend growth stocks, together with ongoing exposure to oil, food stocks, mining services (drillers) and the precious metals.
In the face of all of the above headwinds, uncertainties, geopolitical concerns, and a failing to lead government (aka politics as usual) the market continues to move generally higher. Our path will remain disciplined. We will continue to focus on stable income producing vehicles and MLPs and will try to capture some growth from select holdings. We continue to be cautious and maintain what we consider to be positions in dividend paying stocks, with some protection in the form of precious metals, material stocks, and energy stocks if inflation and/or deflation becomes a real factor. We will remain ready to exit the market to avoid market extremes if we deem it necessary to protect capital.
Past performance is no guarantee of future results. The information contained herein is based on internal research derived from various sources and does not purport to be statements of all material facts relating to the securities mentioned. The information contained herein, while not guaranteed as to accuracy or completeness, has been obtained from sources we believe to be reliable. Opinions expressed herein are subject to change without notice.
The performance of DJIA and S & P 500 may be shown as a general market indicator only and should not be considered an appropriate benchmark for individual account performance; the management style for client accounts may utilize positions and strategies, such as covered calls, that are not reflected in the index. Indexes are calculated on a total return basis with dividends reinvested and are not available for direct investment.
