Mid-Year Letter To Clients {Part I}

We will be posting our mid-year letter to clients the rest of this week.  This letter was originally published on July 23, 2012.  Today we publish part I.

Stocks have reacted so similar to last year that I was tempted to simply resend last summer’s letter with your mid-year portfolio summaries and you could be forgiven if you felt as if you had seen this play before. After roaring out of the gates at the beginning of this year, equities stagnated in April and then began a nearly 10% decline as European debt fears came back to the forefront and just as evidence began to appear of an American economic slowdown.   Stocks as measured by the S&P 500 advanced a little more than 8% through June 30^th.  International markets had a much harder time of it.  Most foreign indices either were flat or negative in the same period.   The average stock advanced a little over 6% while stock leadership narrowed.  According to Goldman Sachs, 20 companies {22% of market capitalization} have accounted for 55% of 2012’s year to date return on the S&P 500.*

Stocks have spent the last year gyrating between “risk on” and “risk off” cycles as sentiment has trended between optimistic assessments of US expansion contrasted against global struggles with job creation and excessive debt.  Europe is currently the epicenter of the debt crisis with the focus on those countries within the European Union {EU} that have been unable or unwilling to get their fiscal houses in order. German insistence on austerity has roiled nations such as Spain, Italy and particularly Greece who desperately need stimulus and growth in order to align their economies with their current debt levels. Concern have grown since the spring that economies in emerging markets such as India, Brazil and most importantly China have experienced slower growth and in some cases recessionary pressures.

The US may be thought of as the best house in a bad neighborhood, but our own economic growth has been anemic, as has our record of job creation.  Recent evidence has suggested that growth here is also slowing.  Our political environment is toxic. The recent Supreme Court decision regarding the President's healthcare legislation has likely further polarized a deeply divided electorate and a budget crisis potentially looms come yearend.  Against this backdrop it should perhaps surprise no one that the S&P 500 is essentially flat during the last 12 months, returning less than one percent. 

Stock market trading patterns show an eerie similarity to last year.  Should this pattern continue then we could expect a rather steep selloff starting sometime here at the end of July, lasting through August and perhaps into September.  Likely catalysts for such a decline would be further financial disruption in the EU, evidence that United States economy is slowing more than currently anticipated, events generated from our presidential election or a foreign crisis.  The market may be following last year’s script but the problem I have with this scenario is that these issues are too well known by investors and most negative outcomes have likely been built into current prices, hence the high amount of defensiveness in many professional money manager’s portfolios and the almost record low sentiment for stocks among the investment public.  Still we cannot ignore the possibility that markets could take a turn for the worse so we have the defensive pages of our game plan, nearby.

There are many positive developments that I think bode well for stock prices down the road. Central banks around the world have unleashed a torrent of policies aimed at stimulating economies and at the same time making risk assets such as stocks more attractive. “Don’t fight the Fed” is one of the oldest maxims on Wall Street. Investors are holding trillions of dollars in bond funds and money market accounts earning less than 1%. Eventually that money is likely to look for higher returns and that should make risk assets such as stocks look attractive.  Societies need technological advances in order to continue economic growth.  We are seeing these advances in fields as diverse as energy where new technologies for oil and natural gas extraction are lowering the cost of energy, putting a dent in our dependence on foreign energy sources and creating jobs. There has been a quiet revolution in miniaturization that spans industries as diverse as medicine, aeronautics/defense {drones}, communications {your smartphone} and computing {your tablet}.  US corporations are collectively in their strongest positions in years with strong cash flows and record earnings.

Stocks today are as unloved as an asset class now as any time in my career.  A high degree of negativity has resulted in a drastic valuation compression down to levels usually seen heading into a foreign crisis or at the beginning a recession.  Syria and Iran to the contrary, there is no evidence that we are on the cusp of conflict similar to the Iraq or Afghanistan. Economic data shows that while US growth has slowed down since the spring the evidence is not currently supportive of a recession.

*Long ETFs related to the S&P 500 in client and personal accounts. 
*Source:  Factset and Goldman Sachs Global ECS Research as of July 20, 2012.