The following are some significant events that occurred in the 1st quarter:
- The Dow Jones Industrial Average closed above 13,000 for the first time since May 2008.
- The S&P 500 also had its highest close since 2008; in fact, it had its best first quarter since 1998.
- Parliaments in Germany and Finland approved the second bailout package for Greece.
- The ECB's (European Central Bank) 3 year Long-Term Refinancing Operation (LTRO) was initiated and served its intended purpose of stabilizing the Eurozone.
- The third estimate for 4Q GDP was revised up to 3.0% from the original 2.8%, driven by positive revisions to personal consumption expenditures, nonresidential investment and government spending.
The effect of these events was the return of real confidence to the world’s stock markets which precipitated a rally that started off 2012 with a bang. Equity markets this year have shown a resilience that we have not seen in quite a long time. Just when the world was expecting more financial calamity, the future surprised us all by being better than expected.
Last quarter we noted that we thought the economy could “surprise us to the upside” this year and so far that has been the case. Economic data this year has been quite encouraging, though still a far cry from the robust recovery everyone would prefer. Employment continues to improve, retail sales are rising sharply and manufacturing continues its relentless move upward.
Jobless claims are a good surrogate for the degree to which the economy has had to make necessary yet painful adjustments. Since 2008, our economy has experienced an enormous shift of resources away from the construction industry and the financial industry into other areas like manufacturing. With jobless claims approaching “normal” levels, it's tempting to think that the majority of this adjustment has been completed. For the four month period ending in February, private businesses have added 930,000 jobs, the most since 2006. The unemployment rate has fallen as a result. However, large numbers of job seekers have fallen out of the workforce entirely which has played a role in lowering the unemployment rate as well. Retraining for new jobs takes time. With time we believe that the economy is going to do more of what it has always done - grow.
With that said, there are still economic headwinds to face. High gasoline prices, one of the more publicized issues, serve as an unwelcome ‘tax’ on our economy and have the effect of slowing growth. As we examine the current political environment, we are hard pressed to believe a cogent energy policy that leads to lower gasoline prices will be forthcoming any time soon. There are glimmers of hope though. The natural gas boom coupled with new production of oil in the U.S. will continue to create jobs and has the added benefit of increasing domestic manufacturing activity. Over the last few months, a number of manufacturing companies that use natural gas as a primary input in their products have relocated plants to be in close proximity to large natural gas deposits. Additionally, with this input priced at historic lows, a number of manufacturers are finding it less expensive to operate facilities in the U.S. than in China. Thus our manufacturing base is continuing to grow which is a welcome consequence of cheap energy here at home.
Given these developments, it appears that economic risks are easing. We’re even starting to see firmness in new housing construction which bodes well for GDP. We will need all the help we can get as Europe is falling into recession and China’s economic growth slows, both of which have negative effects on U.S. exporting activity. Thankfully, our economic recovery isn’t dependent on the health of every business sector. Rather, the recovery only needs to advance far enough for the virtuous cycle of growing employment, income and spending to take hold.
After the stunning rally of the first quarter, overall valuations are not quite as attractive as they were at the beginning of the year. On a sector basis, Financial stocks led the way this quarter with Technology stocks a close second. After that, every sector had a positive return except for Utilities. One of the main characteristics of the first quarter was the positive reversal in the stocks that underperformed in 2011. In other words, 2011’s losers have so far this year become 2012’s winners. This reversal is directly tied to the “risk trade” whereby investors have moved into equities as the fears around a European collapse dissipated. The equities they have chosen were the stocks most beaten down last year. In our third quarter letter last year we noted that investors had re-priced shares based on a perceived negative future. This quarter shows what happens to stock prices when the negative future does not come to fruition.
While we do not expect this rally to continue unabated for the rest of the year, we do think that the rally has legs and the underpinning of it is based on a fundamentally improving economy. This economy is nowhere near its potential and given the continued amount of pessimism that exists, we have a hard time believing that the market is pricing in an overly optimistic future. As we review the various sectors we see pockets of overvaluation but we also see areas of deep value. We see value in Energy as well as Financial stocks. Even though Financials have led the way this year, a number of banks and insurance companies continue to sell for well below tangible book value and while some discount may be appropriate given the new regulatory environment, the current discount is greater than we think is justified.
There have always been, and will always be, fits and starts as the market marches forward from a difficult period. If past economic and stock market cycles are any indication, stocks are likely to rise to overvaluation well before economic growth stagnates. Given that we are, in our view, still on the ground floor of an economic expansion, we think it is more likely the current perception underestimates what stocks can do over the next 5 years, especially as the economy picks up steam.
In a reversal from last year, the fixed income market took a back seat to equities in the first quarter of 2012. The broad taxable bond market as measured by the Barclays U.S. Aggregate Index advanced 0.30% for the period. Corporate bonds were the clear leader as this sector returned 2.08%. Corporate bonds issued by financial companies, one of the worst performers last year, returned over 5.0% when concerns regarding the solvency of financial institutions abated once the results of the Federal Reserve stress tests were released. Government Agency bonds with higher coupons and call features also did well as prices did not move much and we collected the coupons.
The Treasury market, on the other hand, did not fare as well. The 30-year Treasury bond fell nearly 8.0% and the 10-year fell 2.25%. We view this as an unwinding of the “flight to safety” affect witnessed last year as opposed to any credit concerns for the Federal Government. If the economy continues to improve we would expect Treasury yields to drift higher (meaning their prices would fall further).
Financial corporate bonds in the five to seven year maturity range still offer compelling value. The excess yield investors earn over the risk free Treasury comparable is still above of 2.75% for issuers we feel are sound. Bonds from Government Agencies that have step-up coupons and call features continue to offer better yield opportunities versus Treasuries as well.
The tax free municipal bond market was up approximately 1.5% for the quarter on a national basis. Tax receipts in most states are trending above expectations and will continue to ease budget concerns. The Federal Government has been and will continue to lower assistance to states for various programs, most notably Medicaid. While there is uncertainty in this area due to the current political environment, our view is that the municipal market as well as the state and local governments have the ability to adjust to whatever policies come out of Washington. The overall amount of debt outstanding in this sector actually decreased last year as municipalities tightened their belts as opposed to raising debt. We expect a degree of pent up demand for new issuance this year as rates are still very low historically speaking. We believe that investors will absorb this new supply without any problem since demand for tax free income remains robust. We like bonds with 10-15 year final maturities with an intermediate 3-6 year call structure where we can lock in yields that are almost double that of the taxable Treasury equivalent.
As we reviewed our letters from last year it was nice to see that being patient, understanding the adaptive nature of our economy and remembering that emotion does not drive long term value, paid off handsomely. As uncertainties declined, stock prices rose. While we celebrate the rise in equity prices, we also understand that our work is by no means complete. We will continue to watch the global economic and political indicators and invest accordingly.
There is no question that there are dangerous waters ahead for stocks and bonds – both geopolitically and economically. Iran’s desire for nuclear power has not subsided. The U.S. budget deficit and national debt concerns remain on the forefront. Couple those factors with a Presidential election and a massive health care law before the Supreme Court and we see how stocks could fall quite easily – at least in the short term. In the same breath, we acknowledge that predicting the future is a losing game. We strive only to prudently manage potential outcomes.