Q4 2011 Quarterly Newsletter
First and foremost, may we wish you a happy, healthy, and prosperous New Year!
The fourth quarter of 2011 was a great example of why it is dangerous to attempt to ‘time’ or ‘sidestep’ the market when times get tough. On October 3rd (the first trading day of the 4th quarter) the S&P 500 hit 1080 amid panic on domestic economic worries and the European debt crisis. In addition the markets were experiencing extremely high volatility routinely going up or down by 1%-3% per day. It would have seemed completely logical to ‘take risk off the table’ and sell stocks amid the market and economic fear. However, an equity investor who sold on October 3rd would have missed a 19% rebound in a matter of 4 weeks, and by the end of October the S&P 500 touched 1285! This has been the pattern throughout market history, just when it seems like the perfect time to sell, the moment proves to be a great opportunity to invest for the future.
As mentioned above, the 4th quarter of 2011 was one the best in years (in stark contrast to the prior quarter which was one of the worst). The S&P 500 gained 11% during the 4th quarter, trading in a 205 point range which was historically wide. Amazingly, despite severe European debt concerns, domestic recession and debt downgrade worries, and nearly unprecedented market volatility the S&P 500 ended the year exactly where it started on a price basis. When you include dividends the S&P 500 index was up 2% for 2011.
The fourth quarter was generally marked by a ‘disconnecting’ of the European debt crisis from US equities and an overall firming of US economic data.
After a horrible summer and beginning part of early fall, the US equity market seemed to disconnect what was occurring in Europe and the latest economic data coming out of the United States. For several months our markets were being ‘controlled’ almost exclusively by what was happening in Europe on a daily basis. Through the fall and continuing into the early days of 2012 we see that relationship beginning to falter. For the past 1-2 months US equities have traded more on corporate earnings, unemployment reports, and domestic economic factors rather than the 10 year bond rate in Italy. This is a good sign, and if this continues expect volatility (although most likely remaining elevated) to be significantly lower than last summer.
In addition, several US economic data points have been stabilizing, if not modestly improving, since the summer. One of the most important of these factors is the unemployment rate. The jobs picture, through October, was very disappointing with the unemployment rate stubbornly steady between 9% and 9.2%, and the U-6 rate (a measure of unemployed and underemployed) near 16.5%. In addition weekly jobless claims were trending at the 400,000 level which is not consistent with an improving job picture or economy.
The most recent unemployment data, released last week, showed a drop in headline unemployment to 8.5%, and the U-6 rate decreasing to 15%. Although unemployment remains at historically high levels, recent data suggests that the jobs market is slowly improving.
During the past few months jobless claims seemed to have settled below 400,000 and the most recent number fell to 375,000 which is the lowest reading since June of 2008.
Another factor is the continuation of positive growth in US corporate earnings. From 2010 to 2011 total S&P 500 earnings should increase approximately 14% to the $96 level. All sectors of the S&P 500 experienced revenue increases except for the financial sector.
Other economic indicators and data points remain mixed, but it is impossible to deny that there has been at least a marginal improvement in a lot of economic data over the past quarter. The stock market has not ignored the improving data and rose 11% during the period.
Foreign markets remain murky, with cautious economic signals continuing to come from emerging markets and the European debt crisis remaining a large risk. Valuations, on the other hand, have improved markedly in Europe, Asia, and Latin America over the past year (foreign stock markets were down between 10%-20%). Although this has made long term returns prospects more favorable, special care needs to be taken on how to take advantage of these opportunities.
In the last newsletter we stated Traphagen was looking to gradually inch away from our ‘hard defensive’ stance within all asset classes given the right market conditions. In October, we began to move away from the ‘strong’ defensive stance, and will continue to do so in a measured way going into 2012.
Traphagen Portfolio Update/ Comments and 2012 Outlook
We continue to keep all portfolios substantially invested since holding cash generates nominal absolute returns and negative real returns. We also continue to maintain an overall ‘defensive tilt’ in most asset classes. As mentioned prior over the past 3 months we have begun to move away from this more ‘strong defensive’ position. This trend most likely will continue into the first part of 2012, although our ‘equity hedge’ positions will remain in place.
The strong defensive stance served us well in 2011. While we dramatically cut down volatility in all portfolios versus the S&P 500 and the appropriate blended benchmarks performance was not sacrificed. Almost all portfolios (except for some of the most aggressive) returned more than the S&P 500 with 45% to 85% less risk.
For 2011 our equity-option overlay hedge returned 1.7% virtually matching the S&P’s 2% return but with approximately 90% less risk than the S&P 500. More importantly when stocks moved down this security tended to move up, partially offsetting equity losses for the total portfolio.
During the past year our volatility hedge (EMERALD) was exactly unchanged. This behaved as expected, as when the market is flat or positive this hedge is designed to ‘fade into the background’ and not damper positive returns. During the period of mid August through November when volatility was at its highest the hedge performed well increasing about 10% over that period.
Our significant underweight to foreign equities proved to be one of the best decisions we made last year largely shielding portfolios from foreign markets falling 10%-20%. The drop in value has produced good values in European and emerging market stocks. Traphagen is in the process of increasing portfolio weightings to foreign stocks in a focused and cautious manner. We will largely avoid foreign financial stocks, overweight more defensive dividend paying foreign companies, and also have an overweight to countries such as the UK, Canada, Germany, France, etc. We may also consider hedging some of the currency risk in holding these shares as we expect the Dollar to rise against most foreign currencies in the short to intermediate term.
Domestically, we have already exited our overweight to the utility sector (after utilities rose nearly 20% in 2011), and look to equal weight (not overweight) financials that have no direct exposure to Europe (namely regional and local banks). We were underweight financials for the duration of 2011 and that helped immensely as the sector as a whole was down 17% in 2011. Some of these companies have been punished merely for being ‘financials’ even though they have no direct exposure to Europe. Regional banks do have exposure to the domestic housing sector, but home affordability has gotten to a point, in most areas of the country, that argues for at least a stabilization of housing prices. This would be a positive for many of these banks.
We will look to retain an overweight to high yield bonds, as this sector looks favorable on a valuation basis, is less volatile than equities, and currently yields around 7.5%.
In summary, we are remaining on the defensive side of ‘neutral’ within all portfolios but to a lesser extent than in 2011. You have already seen some adjustments and will continue to see some more as we position portfolios to reflect changes in the worldwide equity and bond markets.
Traphagen’s view for 2012 remains cautiously optimistic. Job seekers see more hope than they have in nearly 3 years while other areas of the domestic economy shows signs of stability and even modest improvement. Europe remains a large concern and this is the main reason we are retaining our defensive tilt in most portfolios and are keeping the equity hedges in place. We expect volatility to remain high until the European debt crisis is addressed on a more permanent basis. If and when we see improvement in Europe we would be open to taking a more optimistic portfolio stance. Until then however, for all but our most aggressive portfolios, delivering competitive investment rates of return consistent with capital preservation remains our primary objective.
We wish you all the best as we press forward into 2012 and through the winter season. As always, we appreciate the trust you have placed in us, and look forward to working with you in both safeguarding and growing your investment portfolios during the new year.
Below you will find an addendum highlighting our thoughts on specific market sectors for Q4 2011.
Equity Market Update (Q4 2011)
The equity market (as measured by the S&P 500) had one of the best quarters in the past several years during Q4, gaining 11.5% on a total return basis. The top performing sector for the quarter was the industrial sector up 15.5%. All major S&P 500 sectors were up in the period with some of the more defensive (healthcare, utilities, and technology) up the least with still great returns of between 7% - 9.5%. This quarter left the S&P 500 exactly unchanged on a price basis (closing at 1258) and up 2% while including dividends for 2011.
With a strong outperformance of defensive sectors and stocks for the first 9 months of year, there was some rotation into more aggressive issues as economic data improved and short term fears for a Europe receded. It should be noted in 2011, defensive sectors vastly outperformed the more aggressive sectors, with utilities returning nearly 20% for 2011 and consumer staples and healthcare returning more than 10%.
Q4 started off very volatile, however as the autumn wore on and Europe concerns faded (at least temporally) volatility decreased substantially. At the beginning of the period the VIX (the most common measure of volatility) was around 35-40 and by the end of December it had fallen 35% to near 25 (which is still historically high).
Fixed Income Market Update (Q4 2011)
The fixed income market had a very unexciting quarter. The 10 year treasury yield remained virtually unchanged at around 1.95% (trading in a relatively tight range of between 1.8% and 2.2%). Intermediate term treasuries returned 0.5% for the quarter, investment grade debt returned 3.0%, TIPS returned 2.0%, and national municipal bonds increased 3.3% (on a tax adjusted basis). High yield bonds (which trade very similar to stocks) were the best performing fixed income sector returning nearly 10%.
We continue to hold a 4-5 year duration within the fixed income sector (which is fairly defensive) with some smaller positions in long maturities. We also continue to trim some of the longer dated bonds as further meaningful gains seem unlikely.
Alternative Market Update (Q4 2011)
The real estate market had a very good quarter rising around 15% on a total return basis. This was better than the equity market in general. Yields within the real estate sector continue to be historically low and remain in the 4% range.
Overall, the commodity market had a subpar quarter when compared to most other asset classes. The ‘broad basket’ of commodities rose almost 5%. The one notable exception was oil, which rose an astounding 24% during the last 3 months of 2011. While this does signal increased worldwide economic activity it also acts as a headwind for many US consumers. Master Limited Partnerships were the best performing sector within the commodity space returning nearly 13% on a total return basis. Virtually all our clients hold MLPs within their commodity allocation.
Best regards,
Your Traphagen Investment Team