June 2012 Market Outlook
“The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design”–Friedrich A. Hayek
As we approach the mid-point of the year, we can’t help but feel that we’ve seen this movie before; a relatively optimistic first quarter—followed with evidence of slowing growth—resulting in heightened volatility in the second and third quarters (often accompanied by external shocks), and ultimately ending in a fourth quarter rally based on renewed optimism that what didn’t transpire this year may transpire next. Whoops—don’t want to jump ahead just yet! We must admit that the uncanny repetition of this cycle, now in its third year, sparked our skepticism of stock market levels in our April Outlook; “Sell in May and Go Away”.
The underlying fundamentals are frankly more problematic than the simple prospect of “inching” incrementally higher through each cycle. This year has seen numerous democratic elections across the globe, the most prominent of them getting underway here in four months. Reflecting on recent and current financial events, our impression is that we are witnessing developed democracies all over the world coming to grips with what we’ll term a long term cognitive dissonance among electorates. Politicians do what politicians do, yet for decades voters have repeatedly placed the architects of today’s seemingly intractable fiscal conundrums in federal office, oftentimes for multiple terms, presumably in return for their promised chunks of public largesse. Politicians are simply the artists practicing the art of carving these electorates into their necessary strategic groupings.
Hayek’s comment listed at the top of this page was made in the mid 20th century classic, The Road to Serfdom, and refers to the “elitism” within the hierarchy of western political and academic circles in their pursuit of planned economies. About 100 years prior to Hayek’s observation, Alexis de Tocqueville wrote in Democracy in America; “The American Republic will endure until the day Congress discovers that it can bribe the public with the public’s money”. The irony here is that de Tocqueville was a Frenchman (a “European” in today’s world) observing America’s nascent self-government, and today we can gaze across the Atlantic back at Europe and observe the product of top-down redistribution of the public’s largesse. Why shouldn’t the Greeks be able to retire at 47—as long as the German’s have the capacity to pay for them? As we speak with clients around New England and the country, our impression is that individuals all seem to grasp that the slow-moving European fiscal disaster that has taken place over the last few years is, in fact, our future given the current trajectory of the US fiscal imbalances. Yet cognitive dissonance is being counted on as our political leaders begin to ply us with their focus-group tested campaign narratives.
Spain has indeed become the EU’s newest and largest albatross, as we surmised it would in our January Outlook. Spain is not Greece. Spain “matters” in terms of economic size—and potential drag on the entire continent. As Gerald Driscoll wrote in a recent Wall Street Journal column, “How the Spanish banking situation is handled will determine the future of the euro and possibly of the larger European Union. Will [Germany’s] tax payers and those of other solvent countries be willing to fund an even larger bailout of Spanish banks to save impecunious Spaniards?” The question is unsettling to us, given the drawn-out bureaucratic process we’ve witnessed thus far in dealing with the much smaller economy of Greece.
As we write these words, Stockton, CA is set to become the largest US city ever to declare bankruptcy, illustrating the fact that public fiscal fecundity is not a purely European problem.
YIELD
CCR Wealth Management continues to stress portfolio yield as a strategy to smooth out volatile capital markets, and as a source of return in an extremely low growth economic environment. We are actively using equity market dips to pick up high yielding US index ETFs, and we remain committed to yield spread over Treasuries as an important component in our fixed income models (through high yield, floating rate and emerging markets bond investments). We are also adding to portfolio yield with additions to REIT and MLP peripheral sectors.
EQUITIES
- Despite our focus on dividend yield, CCR Wealth Management’s model portfolios seek to remain balanced between “value” and “growth” equity styles. While broader “value” indexes clearly carry higher dividend yields, they are also home to the Financial and Banking sectors. We are on our fifth year of avoidance of these stocks. Banks and Financial issues seem to us better “trading” vehicles than strategic holdings at this point. There remains a distinct void of understanding about how Dodd-Frank regulations will affect their ability to hedge themselves, or even profit from an eventually expanding economy. Additionally—there are too many unknowns in our opinion with regard to the European counter-party risks among some of the larger institutions. For the broader sector, we think risks outweigh rewards at this point.
- Our model small cap equity weighting remains at 10%, and remains distinctly US-oriented.
- We have been analyzing individual portfolios in our client reviews for instances of heavy weightings in Greater European equities. We should note that we remain international investors; however Europe-specific exposure should be reviewed and in some cases reduced, given the longer-term nature of their growth problems.
In contrast to our European outlook, we actually remain steadfast in our allocations to emerging markets. Unfortunately, it is unrealistic to expect significant performance advantages in the near-term given the economic slow-down in the United States and the recession in Europe. However, we reiterate a point we made a few years ago in that the rise of these growth economies is largely tied to demographics and global technological advancement. Strategically, their future remains bright—though on a relative basis. One tactic we have pursued within the last two years is the meaningful inclusion of emerging markets debt as a component of our model allocations. Emerging markets bonds, along with stocks, had a bumpy ride in 2011—yet these bonds have bounced back with significant advances. We attribute last year’s dip to pressure from forced selling by European Banks (what else?) as they strove to raise cash in the midst of last year’s pandemic fears. We are reasonably confident that this particular risk is in the past.
COMMODITIES:
Perhaps nothing has reflected global economic sentiment more acutely that the commodity markets. The WTI crude price has slipped 26% from its March levels ($110 to $83.5), and Brent has seen a similar tumble. Industrial metals, particularly copper have also reached new lows recently after an initial rally at the start of the year. Gold remains flat for the year—but seems precariously perched around the $1,550/oz technical support level, and Silver is down year-to-date. About the only commodity group showing positive pricing are certain agricultural crops (corn, cotton)—due primarily to weather conditions in the US.
Most CCR Wealth Management portfolio models include a long-term allocation to commodity elements. We have recently reduced our weighting to 4%-6% from 6%-8%. On a relative basis, we view the most favorable commodity holdings to be oil and gold at this point. Oil prices are approaching cyclical lows—and putting aside the myriad of other economic concerns—we hope lower oil prices help sustain what economic activity there currently is. As we’ve mentioned before—oil also has the property of a geo-political “hedge” to justify its place in the portfolio. Gold, of course, is a widely held commodity which can offset the multitude of currency concerns that exist in today’s world.
