The first quarter of 2012 demonstrated that the market truly cares more about economic fundamentals and earnings than just about anything else. In spite of the media’s attempt to spoon-feed consumers its best-selling commodity (sensationalism), the market instead focused on our sobering economic recovery, driving share prices up in an impressive fashion.
It’s a pretty simple formula – as companies participate in the recovery, their earnings increase and so does their ability to pay out a portion of those earnings to shareholders in the form of dividends. Investors are willing to pay more, over time, for that eventual rising income stream which offers the only sustainable and liquid source of inflation protection. Even Apple Computer (AAPL) finally capitulated, announcing on March 19 it would initiate a dividend. AAPL made so much money they simply had to give some of it back to shareholders in the form of cash. Steve Jobs is currently rolling over.
The first quarter of 2012 turned out to be the best start to a new year for U.S. stocks in over a decade. The period also witnessed a doubling in price (excluding dividends) for the Dow Jones Industrial Average from its March, 2009 low, and it topped 13,000 for the first time since before the Great Recession began. As stated above, prices follow earnings and earnings have almost doubled from recent lows.
All this, and many investors are still sitting on the sidelines waiting for proof the world is not going to implode. Unfortunately, since markets are anticipatory, that proof will always come too late. Those waiting on confirmation before acting are playing a loser’s game. The media will always sensationalize the News du Jour in a context of fear or euphoria (often simultaneously). Investors reacting to that mantra will usually sell when they should buy and buy when they should sell. It doesn’t matter if AAPL is topping $600 per share (euphoria) or that oil is $109 per barrel (fear). The media is going to tempt you to abandon logic and make an impulsive decision which can ruin years of prudent decisions.
Much pain could be avoided if investors simply tuned out the media and stopped trying to second-guess the market’s next move. Our contention is that the near-term direction of markets is unpredictable. In the context of investing, the main point is to have a well-defined plan designed to help you achieve your goals with reduced risk and at the lowest reasonable cost. Additionally, that plan should be funded by a prudently diversified and properly allocated investment portfolio. With tax-season ending, now would be a good time to turn your focus toward reviewing and reaffirming your financial goals.
Market Summary
Large, mid and small U.S. stocks gained 12.6%, 13.5% and 12.0%, respectively during the first quarter. During the same period, developed and emerging international stocks gained 10.9% and 14.1%, respectively. Financial stocks were the best performing sector in S&P 500 during the quarter (up almost 21%), as the Federal Reserve’s stress-test gave most of the banks a passing grade in the event of a sharp economic downturn. This is yet another example of why we prefer a diversified all-cap strategy over trying to predict this year’s winners and losers. Anyone who witnessed the pain of financials in recent years would have been hard pressed to predict their stellar performance now.
After a great year in 2011, U.S. Treasury bonds suffered their worst quarter since 2010 as interest rates rose slightly with continued improving economic conditions and investors moving out of safer assets. Shorter bonds fared better than longer maturities. Barclays Government/Credit indexes posted returns of 0.54%, 0.72% and -2.12% respectively for short, intermediate and long maturities.
At this phase in the interest-rate cycle many may wonder why own bonds at all? We include bonds, not for their meager income, but to temper the volatility associated with stocks. Experience has demonstrated that most investors cannot tolerate the volatility of an all-stock portfolio during severe bear markets like those we’ve experienced twice within the past decade. Since we don’t know when the next downturn will come, we are content to insure against an impulsive flight response by adding shorter-term, lower yielding bonds to all but our most aggressive accounts.
Economic Summary
The economy is definitely moving forward, but at a snail’s pace. It’s almost like riding a bike up a steep hill, down-shifting into a very low gear so you don’t fall over. You make progress, but it sure is slow-going. The third and final estimate for 4th quarter GDP came in at an annualized rate of 3.0%, much better than the 3rd quarter’s 1.8% pace. However, 2011 grew only 1.7%, way too slow given this stage in the recovery and about half of the 3.0% pace of 2010. Typically, the deeper a recession, the higher the bounce-back, but this is obviously not a typical recovery.
Housing data show signs of stabilizing yet continue to be a drag on the economy. Record low interest rates combined with lower prices are having a positive effect. A huge inventory over-hang and long sales cycle are the result of millions of people who either can’t afford to buy a home or may not be able to hold on to the one they have. According to Moody’s Analytics, sales of foreclosed homes will rise by 25% in 2012, up from 1 million in 2011. A year-long probe of foreclosure practices had kept many bank-owned properties off the market. This bulge coming through the pipeline is predicted by some to decrease home prices another 10% in 2012. There is a bottom in the housing market, but it won’t come until these properties have been flushed through the system.
What’s Next?
As the consumer goes, so goes the economy. After nose-diving during the recession, consumer spending has recovered nicely. With the Federal Reserve continuing to prime the pump by holding interest rates at or near zero, borrowers can certainly better afford big ticket items like cars and houses. It all comes down to confidence. Oil prices and prices at the pump are up which is causing concerns about a “phantom tax” effect. That’s when high fuel prices leave consumers with less to spend on other goods and services, essentially acting like an invisible tax.
We won’t get initial 1st quarter GDP numbers until late April, but Fed Chairman Bernanke recently indicated an apparent need for continued accommodative policies given that employment is far from normal. March’s jobs report was a disappointment as companies added 120,000 new jobs, about half the pace of the previous three months. The unemployment rate is moving in the right direction and dropped to 8.2% in March compared to 8.3% in February. However, the falling rate is actually due to a combination of companies increasing their hiring and people dropping out of the workforce. 2012 GDP is estimated at only 2% according to a consensus of economists polled by Blue Chip Economic Indicators. 2% is still positive, but it’s just not growing fast enough to make a substantial dent in our employment situation. It will take GDP growth of about 3-4% to bring employment back to more normal levels. The employment sector must continue to strengthen for recent gains in income and spending to hold.
Although not out of the woods, the situation in Europe is a bit clearer. The EU agreed to another bailout after Greece pushed through the largest sovereign debt restructuring in history ($132 billion) last month avoiding an economic crisis. Technically, Greece negotiated an orderly default, which was better than a disorderly default, and bondholders took huge losses. Greece must now implement austerity measures designed to cut their debt-to-GDP ratio from 160% to 120% by 2020. Our country’s debt situation continues to be a troubling cloud on the horizon. Unfortunately, politicians seem to possess only the will to blame the other party and kick the can down the road. February’s $229 billion deficit was a new monthly record. Either our elected officials will enact a solution or the markets will force their hand by refusing to lend us money at such low rates. Either way, the status quo is going to change. There is no one standing behind Uncle Sam like the EU is standing behind Greece.
On a positive note, our energy industry is creating thousand of new jobs as it liberates natural gas and oil reserves from shale formations across the country. Some estimate that we may be able to meet much of our own energy demand for decades to come. The lower cost of natural gas is certainly a boon to consumers of that product. Our economy is obviously not growing fast enough and earnings growth could very-well slow down. If that happens stock prices will likely pull back for the same reason they have gone up so much recently. However, for long-term investors (the only kind who should own stocks) any pull back in prices could offer a buying opportunity.