After a strong 2012, the market continued its ascent in the first quarter, shrugging off macro issues like the Sequester and the Cyprus “bail-in.” The S&P 500 rose roughly another 10%, reaching a new all-time high. Normally when stocks are moving higher at a fast rate, it is the economically sensitive sectors that lead and the defensive ones that lag. But the first quarter saw the reverse, as the top three performing sectors were the three traditional defensive ones: healthcare, consumer staples and utilities. It would be odd enough to have one of these sectors excel in an up market, but to have all three occupying the top three slots is highly unusual. A case can be made that this type of leadership augurs poorly for near-term returns, as it signals lack of faith in the economy.
There is another more benign explanation for the strange sector performance. With bonds offering paltry returns, investors remain hungry for current income, or yield, and as a result are bidding up shares where this yield is found: the three aforementioned defensive sectors. Interestingly, as recently as mid-2012, the highest yielding cohort of the market, when compared to the highest dividend-growing cohort, was trading at its second highest relative valuation in the last 60 years.
So the market has been strong, but the defensives have fared unusually well. This is one of many apparent contradictions in the market. Another: investor surveys and other sentiment indicators point to elevated bullishness, but, again, the preference seems to be for the safer areas of the market. In addition, while sentiment measures are high, many people we talk to are still cautious. On the economic front, corporate profitability is excellent, but hiring has been moderate. The Fed continues to be extremely accommodative, but inflation remains in check.
The US isn’t the only country with easy money. The Bank of Japan recently embarked on an all-out assault on deflation, and the planned expansion of its monetary base, relative to its size, is actually greater than the Fed’s, which is enormous. Like the Fed, the BoJ will print money to purchase securities, providing liquidity in the hope that it can generate at least 2% inflation. The Japanese stock market has responded, rising 19% in the first quarter.
In essence, much of the world is engaged in a race to the bottom – a contest to see who can depreciate its currency the fastest. The thinking is that such policy helps exports by making them cheaper and that the liquidity helps boost stock prices, which helps people feel wealthier and therefore more confident to spend money. The purchase of sovereign debt by central banks also has the side “benefit” of keeping interest rates (government borrowing costs) low, which makes it easier to finance the ever-increasing sovereign debt. To central bankers it must feel like a free lunch: inflation is not a threat, so continue flooding the system with paper money and reap the benefits. Of course, this is a risky strategy, as the long-term effects are unknown. It could end up as so many popular Wall Street strategies do, functioning well until it blows up.
So liquidity is abundant, and it is helping to boost stock prices. General bullishness has increased, and this liquidity is one of the factors the bulls cite for their optimism. But it is important to remember that, as the old saying goes, liquidity is a coward, as it tends to disappear when trouble surfaces.
Stock fund inflows are the strongest they have been in seven years. Not coincidentally, this was the first first-quarter since 2006 in which the Barclays Aggregate (the most widely followed bond index) posted a quarterly negative return. According to The Wall Street Journal, the annualized total return of this bond index since 1976 was 7.68%. What will it be for the next 37 years, starting from today? Nobody knows. But we do know with 100% certainty that it will be below 7.68%, given the math. There is only so much upside (and plenty of downside) when yields are at 2%.
Our recent moves in portfolios have been incrementally defensive, as we have believed it is prudent to pare back on some of the cyclicality of our holdings, which served us well since the market bottom four years ago. Our experience tells us that the time to do this is when the economy is on relatively sound footing, stock prices have run, and sentiment is healthy rather than when things look bleak and everyone is scared. By becoming incrementally more conservative today – and we would stress “incrementally” - we are providing room to take advantage of future market dislocations, when they inevitably occur. To be clear, we view this as prudent portfolio management (not market timing), and we remain fully invested.
Best regards,
Mark Oelschlager, CFA
Portfolio Manager
Oak Associates, ltd.
© Oak Associates
