Investment Strategies Newsletter
In looking back over the past year, the theme has quite clearly been volatility. In fact, according to a survey by the SEI Advisor Network, “2011 has been a volatile, nerve-racking, sleep-deprived year.” While this rings true, the volatile nature of this year still seemed very different from that of 2008, where a full blown financial crisis haunted investors daily. This year, acute events have caused fear in investors—such as the US Treasury credit downgrade in August or the more recent debt crisis in the euro zone.
Still, the year was an anomaly in a couple of ways—perhaps most notably was that for the first time in over 70 years, the third year of a presidential election cycle did not lead to an overall market rally. In addition, looking back at economists’ forecasts for 2011, most overshot the year, putting the S&P 500, 10-year Treasury note yield, and GDP growth all higher than what they turned out to be. Interestingly, despite the extreme intraday volatility, the year was flat overall.
While the first half of the year was marked by slow economic growth, we saw a bounce in the third quarter, and the momentum from that has carried through the end of the year. There was a clear rise in the economy at December’s close. We saw several analysts’ forecasts beaten or surpassed by actual numbers. Some economists declared that the economy was growing 3 to 4 times as quickly as it was early in the year. While it is always comforting to read healthy economic statistics, especially in hopes of a long awaited recovery, it is likely that the path to sustainable recovery is a long and complex one that won’t be reached merely through some positive economic data. There remain on the scene several systemic issues that we expect to be dealing with throughout the foreseeable future. Let’s take a look at how the last quarter of 2011 unfolded.
October at a Glance
October was an impressive month for the markets, especially after a couple of significantly dreadful days toward the end of September. The S&P 500 rebounded by almost 11%, after being down 7% for September. However, October didn’t defy the trend of volatility that we’ve had to grow so accustomed to the past few months. That volatility has stemmed largely from the European Union. Daily, the European Financial Stability Fund, European Central Bank, and euro zone leaders seemed to be holding yet another meeting and overcoming yet another hurdle on the path to averting both Greek and Italian defaults.
Greece had an eventful couple of weeks toward the end of October. After initially reaching a tenable rescue package for the country, severe unhappiness among the Greek populace caused Prime Minister Papandreau to consider holding a referendum on the bailout plan. However, in the face of pressures from other European powers, Papandreau was forced to drop the issue and look to other means for getting the bailout plan passed.Papandreau formed a coalition with the opposing New Democracy party’s Antonis Samaras. Papandreau agreed to step down as Prime Minister, while Samaras agreed to support the debt deal in return. The country then came to eventual consensus on Lucas Papademos leading the temporary unity government in pushing the bailout plan through Parliament.
A Snapshot of November
November felt like a drawn out round of the waiting game. Americans waited on news of a long-term spending agreement from Congress’ Joint Select Committee on Deficit Reduction, as well as any updates on the euro zone, and simultaneously rode out some pretty awful days in the markets.
On Monday, November 21, just days before the super committee’s deadline, the co-chairs of the committee announced that it was unable to present a bipartisan agreement to the public by its deadline. What Americans had feared, but hoped they had been wrong about, came to fruition before Thanksgiving. Unless action is taken to change the current law put in place this summer, which President Obama has stated he will not allow, automatic spending cuts will go into effect beginning in 2013, which involve cuts to both domestic and defense programs.
To wrap up the month of November, there was a downgrade warning issued to over 80 European banks—but investors didn’t seem to mind too much. The markets saw one of the biggest rallies it had experienced in years, with the S&P 500, Dow Jones, and Nasdaq indices rising 4% or more. Such a rally has only been seen a handful of times since the financial crisis three years ago. Financial entities, in particular, were bolstered by the upward movement in the markets. Perhaps the rally was due in large part to the concerted initiative of many of the world’s leading central banks to lower the cost of emergency funding to European banks. The US Federal Reserve, Bank of Canada, Bank of England, Bank of Japan, Swiss National Bank, and European Central Bank joined together in agreement to lower the interest rate on US dollar liquidity swaps. Essentially, in recognition of the rising expense of European banks borrowing money in dollars, this agreement would encourage banks to borrow by making it cheaper by 50 basis points, or .5%.
Wrapping Up the Quarter
In the second half of December, the number of Americans filing new claims for jobless benefits hit a 3 ½ year low. Other US data has been equally positive, such as higher consumer confidence (partly due to a sizable 70 cent decline in gasoline prices), healthy household spending, and improved home building. The four week moving average, considered a strong measure of labor market trends, dropped to its lowest level since June 2008. According to ISI (International Strategy & Investment) on December 29, unemployment claims were below 400,000 for the 4th week in a row, and for 7 of the previous 8 weeks. Economic releases indicate that real GDP will advance 4.0% or more in the fourth quarter, and payroll employment will also increase. This is all evidence of positive growth, albeit not enough to feel like a true recovery. Housing continues to be the missing piece to the domestic economic puzzle, with data still incredibly weak.
With regard to the European Union, The President of the European Central Bank announced that the Central Bank would offer to lend money to banks for three year terms, in unlimited amounts, at the very low interest rate of 1%. Then, on December 21, the ECB announced that 523 banks would borrow a total of 489.2 billion euros, surpassing most forecasts.
This has acted as a catalyst for restoring hope in many people’s minds about the future of the region. Many economists believe that this aggressive move by the ECB could finally be a defining moment in the euro zone’s debt crisis. It certainly shows some healthy and refreshing initiative to straighten out the region’s fiscal balance sheet. This action, overall, economists predict, could put 190 billion to 270 billion euros of new money into the European financial system.
Where Do We Stand?
The real issue going forward is how the global economy, and the euro zone in particular, will affect our domestic economy which seems to have found its footing and stabilized many of its fundamentals. Some of our growth and recovery will undoubtedly be counteracted by deep recession in Europe, although we are not of the belief that the US will hit a wall of its own as a result. It would be naïve to think that with the ending of 2011 comes the end of 2011’s struggles. This euro zone debt crisis has most likely not yet come to a head, and therefore we will be prepared to deal with its ramifications for the US.
We wish we had answers to the most pressing questions surrounding the situation in Europe. However, inherent in the situation’s risks is the degree to which no one truly knows the implications. As your investment manager, the best we can do is stay on top of our investments and hedge against risk wherever we see necessary.
Volatility remains the name of the game. Fear of the unknown, especially regarding the EU debacle, has taken center stage and precedence over the economic statistics and forecasts that historically drive the markets. At the rate we are going, jockeying between risk-on and risk-off trading is not going to be a thing of the past anytime soon. It seems until the looming nature of debt problems across the pond truly cease, investors will continue to act based on daily updates to the geopolitical scene—hence the ups and downs we have seen throughout the quarter, although we believe the trend will be generally upward.
It remains true that although the threat of recession in Europe looms above us, the US has continued to hold its own throughout the year, with slow growth, just as we have been predicting. Although it certainly hasn’t been a year of a bullish stock market and a booming economy, we cannot complain that in the face of several bleak indicators, the US has managed to hold off recession and grind out some measured growth.
Our Game Plan
As always, we continue to “stress test” our portfolios for downside risk under various possible scenarios. In conducting such analysis, if we identify certain positions that may have significant downside risk, we will act accordingly, by either reducing or eliminating those positions.
Clearly, there are two equally important pieces to the puzzle, and we plan to be both strategic and disciplined in our approach to both sides of the equation: protecting and monitoring our current investments, and looking to seize opportunities in a time where risk and volatility can make good stocks cheap. We have seen the benefits of “riding out the storm,” especially when the storm is one largely driven by emotional fear. The biggest mistake investors can make is to think that the current slow growth environment is not suitable for making money—it just may require more patience and commitment.