In the first half of the year we have seen some of the best and the worst that the markets have to offer. The dichotomy is noteworthy: the first quarter was the best in 14 years while during the second quarter the Dow posted the worst May performance since 1940! With the same surprising speed that confidence was restored in the first quarter, fear and uncertainty returned in the second. The last 90 days have seen a weakening in many economic and sentiment based indicators. Additionally, Europe’s footings that were laid in the first quarter began to topple during the second when the Greek elections called the bailout efforts into question. Consequently, the stabilization of Europe was threatened and as uncertainty was reintroduced into the world’s equity markets, stock prices retreated across the board with a corresponding rise in US Treasuries and bonds. We have often characterized the current markets as “volatile” and the last 6 months were a living definition of that common phrase.
Despite some weakening economic reports, we continue to see data that reflect growth albeit at a lackluster pace. The May and June jobs numbers were anemic and demonstrated that businesses continue to put off meaningful hiring in the face of uncertainty. On a positive note, small businesses have actually become more aggressive in hiring versus their larger corporate counterparts. The overall slowdown in employment gains has not stopped the upward trend in retail sales nor has it kept the housing market from showing signs of life. Both of these factors are quite positive for economic growth. All things considered, it appears that this summer, like the summers of 2010 and 2011, will likely be the weakest point of the year.
Of the headwinds we noted last quarter, the current political situation persists as an element of uncertainty. When media pundits use such terms as “taxmegedden” or “fiscal cliff” it has the effect of slowing economic activity and dampening consumer sentiment. When we face the uncertainty of which political party, and therefore which of the widely divergent policies, will be instituted next year, it makes businesses take caution. The Supreme Court’s decision about healthcare reform is a case in point. It is easy to see why businesses only want to make decisions about what is strictly necessary and wait for more certainty (i.e. another election) before committing for the long term.
So far, as companies begin to announce earnings we are witnessing that the North American market is one of the strongest in the global economy. The downside is that it appears multinational companies may struggle to hit their earnings estimates this quarter due to overseas weakness. Fears over a hard economic landing in China are rampant (hence the decline in Energy and Basic Materials stocks) and while China has real issues economically, we do not share that fear. Europe is in recession and even the strongest economies in South America are slowing as well.
On a better note, gasoline prices which last quarter were trending much higher and crimping consumer spending, have fallen dramatically. The residential housing market has begun to show real strength since last year as new home sales continued to improve, reaching a two year high last month. Residential construction employment growth should increase in the coming months. The employment multiplier related to residential construction is enormous and plays a strong role in the overall economic recovery. While recent employment growth has been anemic, we see indications of continued pockets of strength. Last month, Ford and Chrysler indicated that they were adding shifts and cutting back on the normal summer shutdown in order to meet new automobile demand.
We continue to believe that the recovery only needs to advance far enough for the virtuous cycle of growing employment, income and spending to take hold. For now, “muddling through” seems to be the current state of things, with the belief that in the coming months and quarters the pace will improve.
After the impressive rally of the first quarter, fear and volatility returned to the market with the major sectors finishing lower this quarter. The biggest losers were Financials and Technology with Energy and Basic Materials not far behind. Even with the negative results, the Dow Jones Industrial Average still stands six percent higher for the year to date period.
With volatility increasing, the question must be asked- why continue to invest in stocks at all? When reviewing the alternatives for long term risk adjusted returns, we believe stocks are the best option. For investors with an ample time horizon, we believe many stocks are quite attractive. By one key metric, the dividend yield, stocks are the cheapest they have been relative to bonds in more than 50 years. The yield for the S&P 500 is now over 2%, far above the yield on 10-year Treasuries, the first time this has happened since 1956.
As we noted last quarter, we see value in the Industrial, Financial, and Energy sectors of the market. Once the dust clears in Europe and the US, we see several strong drivers for future growth. In our last quarterly letter we noted that there will always be ‘fits and starts’ as the market marches forward from a difficult period. The strong “start” in the first quarter and the disappointing “fit” of the second were both surprising in their velocity. However, as we pass the halfway mark for 2012, it’s noteworthy that we are right on track for an above “average” stock market return. We have always stated our conviction that predicting quarterly results is a fool’s errand and we believe the next week, month or quarter’s results are unknowable. In this period of volatile market returns, we still strongly believe in the worth of stocks as an investment to generate superior returns. However, it is arguably now more important than ever that investing for the future requires a time horizon commensurate to the task.
As we have witnessed many times over the last several years, when stocks come under duress and economic worries pervade globally, US Treasury bonds perform very well. This was the case during the second quarter as we saw the 30-year Treasury price appreciate over 10% in another “flight to safety” rally, leading the yield to fall to 2.75% from nearly 3.5%. The European debt debacle led investors, including central banks, to look for risk-free assets in currencies other than the Euro. The Swiss Franc and US Dollar seem to be the currencies of choice. Switzerland actually issued a bond with a negative initial interest rate! This only makes sense if investors expect a precipitous drop in the value of the Euro (one would be willing to accept a negative interest rate in Francs if the Euro depreciates by more than the negative rate). Due to this type of panic driven flight to safe-haven assets, we do not currently find Treasury yields attractive.
Corporate bonds spreads did widen during the quarter, and we favor corporate credits versus the Treasury market as we have for quite some time. Spreads on Financial credits offer the highest yield at present. However, we are being extremely selective in the issuers we purchase. Callable step-up Agency securities offer attractive yields as well, and we are purchasing initial coupons of 2% or higher that step up to 5-6% over time.
Municipal bonds turned in a positive quarter as well, returning approximately 1%. We are still able to find tax free yields well in excess of 150% of the comparable taxable Treasury. Municipals offer the best after tax yields available (taking credit quality into consideration) for investors in any meaningful tax bracket. Budget pressures are acute in some states (CA and IL to name two); however, most state revenues have recovered nicely from the recession and in some cases have come in ahead of expectations. We are keeping an eye on tax policy as the Bush era tax cuts are set to expire at the end of this year. Unless Congress changes the law, tax rates will rise and the tax free income stream will become that much more attractive.
As global economic and political uncertainties have reemerged, bond prices have risen and stock prices have fallen. It is important to reiterate that the economy moves slowly. Capital markets, which try to predict economic movement, seem to feel more like a fire hose; either turned off or on full blast. However, the economic cycle is just that, a cycle. It begins slowly, gathers steam as we move through expansion and then slowly matures before it corrects. As we enter what we believe are the beginning stages of economic recovery, we expect the capital markets to experience a continued stream of fits and starts. While headline risks remain, we believe optimism is the rational response given the economic data we follow.