The domestic stock market has demonstrated an uncanny resiliency and resolve of late. The S&P 500 was up 10.6% in the first quarter, closing within 0.5% of its all-time high. This, despite numerous headwinds including a sluggish economy (Q4 GDP growth was an anemic 0.4%), the implementation of the automatic spending cuts which could further weaken economic growth, the still unresolved debt ceiling debate, declining consumer confidence, an Italian electorate that is revolting against Europe’s austerity measures, and the demise of the little island of Cypress which has bank depositors throughout Europe wondering if their savings are at risk of a government-imposed tax. Most of the information flow is signaling caution yet the market surges ahead—what’s up with that?
We think what’s up is that we are in the early stages of a major re-allocation shift among institutional and individual investors. The rise in equity valuations and the decline in bond prices are not due to some newfound euphoria over future economic growth—if that were the case we would expect to see emerging markets leading the pack (down 2% for the quarter), commodities in general (up 0.5%) and particularly economically sensitive commodities such as copper (down 7%) also showing significant gains. Instead, we are seeing the more defensive, higher dividend yielding sectors of the market leading the charge—the Dow Jones Utility Index (4% yield) was up more than 13% for the quarter, the Alerian MLP Infrastructure Index (5.3% yield) was up nearly 20%, and the Bloomberg Mortgage REIT Index (12% yield) was up almost 18%. What’s up is a widespread rotation from bonds to stocks as investors seek out higher yielding assets. The transition makes sense for income dependent investors—intermediate tax exempt bonds are yielding 1.2% and intermediate investment grade corporate bonds are yielding less than 2%.
Our clients’ portfolios performed quite well, on both an absolute and relative basis, in this environment as we have been touting many of these non-traditional higher yielding asset classes for some time now. The global equity portion of clients’ portfolios benefitted from an underweighting in developed international stocks and an overweighting in domestic small- and mid-cap stocks. The returns for both our taxable and tax-exempt bond portfolios were greatly enhanced by their exposure to lower rated high yield bonds. Our holdings of gold and silver as a deflation/inflation hedge, which we were reducing throughout the quarter, was the biggest drag on portfolio returns as precious metals were down more than 5% for the quarter.
With the equity market fast approaching its historic highs it would be tempting to become more defensive. While we wouldn’t be surprised with a modest correction along the way, we believe the overriding upward trend remains intact. Investor asset class rotations, as we are witnessing now, are typically long in duration—they don’t get completed in a few months or quarters, it usually takes a couple years. The headwinds remain but they are also known. Based on the market’s recent performance in the face of some unanticipated shocks (Italian elections and Cypress come to mind), it will take quite a bit to derail this train.
Not to worry, we remain committed to our mandate to build the least risky portfolios necessary for our clients to achieve their financial goals.