2012 got off to a great start for the stock market, with the strongest first quarter kick-off since 1998, and the best overall quarter since the third quarter of 2009. Many of the riskier and “unloved” sectors of 2011 staged a rebound, like developed and emerging markets international stocks, small cap, and financial and technology stocks. In some ways, the quarter was a mirror image of 2011. The defensive and cautious standouts of 2011 wilted, making way for 2012’s more aggressive and economically sensitive rising stars.
In contrast, the bond market faced headwinds in the first quarter with the Barclays aggregate bond index barely finishing in positive territory. Demand for safe but low-yielding Treasury bonds dropped off as better conditions in Europe made the T-bond’s “safe haven” less appealing (long-term Treasuries ended the quarter down almost 6%). Since government-related bonds make up three-quarters of the overall bond index, Treasuries’ struggles dragged down the index’s performance. For the first quarter, the higher the bond quality, the lower the return. “Safe” choices like municipals and TIPs did beat Treasuries, but the better results came from riskier sectors like corporate, high yield, international and emerging market bonds.
Looking back, it was three years ago, in March 2009, when the market began to recover from its lows, the worst bear market since the Great Depression. At that time, the market capitalization (or aggregate value) of the U.S. stock market was $8.0 trillion. By March 31, 2012, it had rebounded to $17 trillion.
Though the stock market is still below its October 2007 highs, the economy is improving, growth is slow but steady, and unemployment is easing. Yet, many investors are still wary of the market and in 2011 withdrew money from stock funds for the fifth year in a row. Of course, as usual, there is no shortage of worries: European debt, Iran and oil, China’s slowdown, market volatility, political change. But what is certain is that, given current economic conditions, traditional savers are not being rewarded, and are in fact being penalized. According to data compiled by Investment News, “a balance of $10,000 would have earned $184.60 in interest since December 2008. For Treasuries, the return was $1,644. U.S. equities generated $5,690 including dividends.”
Does that mean every investor should pile into stocks? Of course not. But investors should determine an asset allocation strategy that makes sense for them given their goals and risk tolerance and stick with it, understanding that stocks, bonds and cash all embody elements of risk and reward.
What’s Ahead in 2012
The U.S. economy is slowly improving. That suggests a cautiously optimistic outlook for stocks as well as bonds. Bonds have enjoyed a strong, thirty-year bull market, but is that run soon to reach its end?
The Fed has said it expects to hold rates steady until 2014. The purpose of lower rates is to keep consumers spending, and companies hiring and investing in new products to encourage economic growth. However, if the economy heals faster than expected, the Fed may be tempted to start raising rates before 2014. That said, the Fed knows that if threatened budget cuts and tax hikes kick in starting in 2013, they will act as a “drag” on the economy, making a toxic economic cocktail if mixed with higher rates. That may give the Fed pause until they can see how Congress and a new President handle the taxation and budgetary impasse.
Even if rates nudge higher, it may not be the end of the world. “If we move higher from here, it’s because the economy is getting better,” said Ira Jersey, interest rate analyst at Credit Suisse, interviewed by the Wall Street Journal. The last series of rate hikes was from June 2004 to June 2006, when the Fed hiked rates 17 times (from 1.00% to 5.25%). Yet, during that period the S&P 500 rose over 15% and the bond index rose almost 6%. The silver lining of rate hikes? While current bond prices take a hit, income flows increase as maturing bonds are replaced by new bonds with higher yields.
Some thoughts on strategy:
- If you are still on the fence about refinancing mortgage debt, let us know so we can help you with the analysis. This low-cost debt window may start closing soon.
- We continue to focus on opportunities in the bond world away from Treasury and other government debt, which pays too little given the risks of eventually higher rates. It is much harder now to generate good returns in bonds, meaning the skill and expertise of a seasoned bond manager is invaluable and well worth paying for.
- Stocks are arguably more attractive investments than bonds, given the potential for future inflation and rising rates. However, we feel global and earnings uncertainty is sufficiently high that investors should not take on more risk, above and beyond their normal asset allocation, in search of returns.
- Your asset allocation should be reasonable given your age, resources and needs, avoiding either the “low” or “high” extremes. It is not a good time to be making “bets” on the economy as the uncertainties make upside and downside risks well-balanced.