A good month and a great quarter
March carried on with strong market performance, capping the best first quarter since 1998. Although the monthly returns for domestic markets were slightly less robust than in the first two months, they remained positive in March, at 3.29 percent for the S&P 500 Index and 2.15 percent for the Dow Jones Industrial Average. The two indices returned a total of 12.59 percent and 8.84 percent, respectively, over the quarter. Foreign markets also had a strong first quarter but suffered from a weak March, with the MSCI EAFE Index falling 0.46 percent and the MSCI Emerging Markets Index declining 3.52 percent. The differential reflected stronger economic performance in the U.S. compared with other areas of the world.
For U.S. markets, technical factors remained supportive, with the 200-day moving average still in an uptrend and the 50-day still above the 200-day. The S&P 500 again ran through potential resistance levels of 1,370 and 1,400. Looking at market internals, growth outperformed value, as investors returned to a more “risk-on” trade, and financials and technology led the pack for the quarter as a whole.
Such strong first-quarter performance is relatively rare. This chart shows returns over the rest of the year for periods when the S&P 500 gained more than 7 percent in the first quarter—a value chosen as a reasonable approximation of a typical full-year return.
Although historical patterns may not be repeated in the future, overall, results look encouraging. Average additional returns after a 7+-percent first quarter have been nearly 8 percent, excluding dividends, and eight of the nine years have been positive. These seem like pretty good odds, but the inclusion of 1987 in this list reminds us that risks remain.
The Federal Reserve and interest rates
Broad bond portfolios appeared to be in a holding pattern over the first three months of the year. The Barclays Capital U.S. Aggregate Bond Index returned 0.3 percent. Riskier debt performed better, with the Barclays Capital U.S. High Yield Index posting a 3.54-percent price return.
The Fed showed no inclination to raise rates or introduce QE3. The 10-year Treasury yields remained at historically low levels throughout the quarter. They did, however, increase substantially in late March, before subsiding, suggesting that the low rates remained susceptible to market pressures.
Another issue with rates is based in price discovery. The Fed has been buying a very large proportion of Treasury debt. This has kept the market from determining the fair value of government debt without the impact of purchasing, adding to the uncertainty associated with future Fed actions.
Finally, the potential resumption of economic growth raises the question of when and how the Fed will start to drain excess reserves from the banking system. This must be carefully executed lest excessive inflation result—though the bias of the Fed is toward inflation rather than deflation at this time. As a result, the risks of inflation in the medium term cannot be ignored.
Over to Europe
The first quarter saw many developments in Europe. Greece completed its default on outstanding debt, which included “voluntary” participation from the private sector. Interestingly, bonds issued as part of the settlement are now trading at a discount, suggesting that markets expect a further default. Still, with the Greek situation seen as settled, at least for the moment, concerns have shifted to other countries, with Portugal, Ireland, and Spain at the head of the list.
Portugal seems to be in a similar situation to Greece, though it has made substantial efforts to comply with European Union requirements and is small enough to be rescued. Ireland is in much the same boat. Spain, however, is much larger and its problems could lead to a resumption of the crisis. That said, the European Central Bank has largely removed liquidity risk from the financial system with its Long-Term Refinancing Operation. A sort of circuit breaker, it could make contagion less likely, at least for the next couple of years. Therefore, while risks remain, market perception seems to be that the European situation is under control.
A quarter of good economic news raises investor confidence
The U.S. economy appears to be growing at a moderate clip, and expectations are for growth to have averaged approximately 2 percent in the first quarter of 2012—not remarkable, except that in late 2011 many had feared a contraction. Equally important for the investor psyche is the unemployment rate, which has continued to show signs of slow improvement, falling to 8.3 percent, after hitting 10 percent in 2010.
Employment growth has supported increased consumer spending, which has, in turn, provided support to the economy against decreases in exports, as other areas of the world have slowed. The consumer savings rate, although lower in the past quarter than in recent years, is still reasonably healthy, suggesting that these spending levels may be sustainable.
Consumer spending also has bolstered industrial production and manufacturing, which have continued a trend of improvement that began in 2009. While manufacturer sentiment has been less optimistic recently than through most of 2010 and early 2011, a positive trajectory has remained.
Market commentators and investors seem to expect a housing bottom and rebound in 2012. Homebuilder share prices rocketed upward during the quarter, nearly doubling the return of the S&P 500. Indeed, home prices net distressed sales started to increase, suggesting that the market has begun to heal. Some markets have also shown overall price increases. That said, according to the Case-Shiller Home Price Index, home values continued to fall in January, although less quickly than in previous months. The future may likely depend on the degree to which new foreclosures are put on the market.
A strong base but continuing headwinds
The U.S. economy has continued to exceed expectations, showing positive trends through quarter-end. Headwinds include slowing economies elsewhere, high oil and gas prices, and uncertainty associated with the European situation and Iran.
This is the third year in a row where the end of the first quarter has looked good, but growth looks more sustainable this year. Given the headwinds, however, investors would do well to stick to their long-term portfolio allocations and resist the urge to take on too much risk.
Disclosure: Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets. All indices are unmanaged and investors cannot invest directly into an index. The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. The Dow Jones Industrial Average is a price-weighted average of 30 actively traded blue-chip stocks. The MSCI EAFE Index is a float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI Emerging Markets Index is a market capitalization-weighted index composed of companies representative of the market structure of 26 emerging market countries in Europe, Latin America, and the Pacific Basin. It excludes closed markets and those shares in otherwise free markets that are not purchasable by foreigners. The Barclays Capital Aggregate Bond Index is an unmanaged market value-weighted index representing securities that are SEC-registered, taxable, and dollar-denominated. It covers the U.S. investment-grade fixed-rate bond market, with index components for a combination of the Barclays Capital government and corporate securities, mortgage-backed pass-through securities, and asset-backed securities. The Barclays Capital U.S. Corporate High Yield Index covers the USD-denominated, non-investment-grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below.
Authored by Brad McMillan, vice president, chief investment officer, at Commonwealth Financial Network.
© 2012 Commonwealth Financial Network®