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Katrina Lamb, CFA
Head of Investment Strategy & Research
Katrina Lamb’s international investment industry career spans more than 25 years and includes both buy and sell side experience. She specializes in the research, analysis, and evaluation of the capital markets opportunities that... Full Bio
Will there be a party? Probably not – 1527 is not the S&P 500 all time high water mark. But it is a significant milestone for longtime market observers because it was the peak achieved during the technology bubble; to be specific, the closing price of March 24, 2000. Putting that milestone behind us for once and for all would at least merit a glass of Veuve Clicquot, if perhaps not a truckload of cases of that fine eau de Champagne. It is most likely only a matter of time until we reach it, with today’s (2/13) intraday high breaching 1524 before settling back to close just above 1520. But it could be awhile before we wave goodbye forever.
Animal Spirits or Defensive Crouch?
Of course the S&P 500 is only one index, and it doesn’t move in a vacuum. As this broad US equities benchmark has rallied since the beginning of the year how have other asset classes fared? Relative movement patterns between a blue chip index like the S&P 500 and other benchmarks can act as a sort of sentiment gauge. Strong relative gains by asset classes like small caps or emerging markets can act as a market sentiment gauge. When exposures like small caps or emerging markets perform relatively better than the blue chips it can signify an uptick in animal spirits – a willingness to push out the risk frontier. Conversely, when a defensive sector like utilities outperforms it can imply a more cautious, defensive sentiment.
With that in mind what does the data tell us today? Well, something of a mixed bag actually. The Russell 2000, a popular small cap benchmark, has outpaced the S&P 500 by a bit more than 1% since the start of the year, though in the last couple weeks sentiment has been slightly more in favor of the blue chips. On the other hand the MSCI Emerging Markets index has substantially underperformed the S&P 500 over the same period, and is barely in positive territory for the year to date. Developed non-US indexes like the MSCI Euro and MSCI Pacific ex Japan are likewise lagging the S&P 500. Meanwhile the Dow Jones Utility Average, a traditional defensive haven, underperformed the S&P 500 during the torrid January rally but has since been steadily gaining ground in relative terms.
All of which is to say that there is not a compelling case to make for animal spirits run rampant, nor is there solid evidence of an imminent defensive crouch. None of which is unusual when a major market index like the S&P 500 hovers around a macro trend barrier. The high frequency trading platforms that dominate day-to-day volume are programmed to advance and hedge, advance and hedge, not unlike a tactic one might encounter in Carl von Clausewitz’s timeless military strategy classic On War. Directional allocation calls (e.g. on small caps or utilities) are tough to execute when the ground is constantly shifting underfoot. A better approach may be to stay nimble, with one foot further out the risk frontier and one foot closer in, until a yet to be known catalyst moves things more decisively in one direction or the other.
As of the February 6 close the S&P 500 was about 6% higher for the year to date in terms of price appreciation. The Dow Jones Industrial Average was ahead by 6.7% for the same time period. Interestingly, both averages are very close to their all-time high water marks. And both are flirting with big round numbers; the S&P 500 oscillates around the 1,500 mark while the Dow plays footsie with 14,000. It may sound silly, but historical patterns show that these big round numbers actually can be formidable support or resistance levels. Call it irrational investor psychology – but that’s what the numbers say. So at this juncture a few questions are in order. Does this rally have the legs to carry us into macro growth market territory? What are the risks that could keep things lurching along around these resistance levels for awhile? Could things get really bad again – are investors too blithely complacent about potential X-factors that could send things heading sharply south?
Those all-time high water marks (14,164 for the Dow, 1,565 for the S&P 500) are fueling lots of chatter about the so-called “Great Rotation” – a structural shift from fixed income into equities. One could ask, is the Great Rotation any more real than the Great Pumpkin of “Peanuts” fame? Perhaps. Or perhaps not. The bulls point to the $11.3 billion net inflows that came tumbling into US equity funds in the first two weeks of 2013. That’s the biggest fortnightly inflow since April 2000. The bears say…yeah, April 2000. Remember what happened after that? Ouch.
But market conditions today are hardly like they were in that last dizzying month of the dot-com bubble. Equity valuations are much more modest – maybe not screaming bargains but not wildly overpriced either. And, lest we forget, the yield on the 10-year Treasury was over 6% in the first quarter of 2000. If anything could drive frustrated yield-seekers out of bonds and into equities, then the fact that in inflation-adjusted terms you actually have to pay to own the 10-year Treasury – surely that should be at the top of the list of reasons, no?
Great Rotation or not, we do believe that the landscape looks reasonably promising for equities in 2013. But we also don’t think it’s going to be a one-way joyride upward. The market still moves more to the utterances (or non-utterances) of Ben Bernanke or Mario Draghi on any given day than it does to factors more directly pertinent to the business value of the companies that make up the indexes. The 10-year yield is still mostly below 2%, meaning that any Great Rotation money that’s out there still has one foot planted in the bond market while it gingerly treads further into equities. And brisk rallies like the one we’ve seen since the beginning of the year – especially when contending with macro-trend resistance levels – are vulnerable to significant corrections before they finally succeed in scaling the wall. We have to be prepared for perhaps a bit more volatility than we’ve had to deal with for awhile.
This January the first exchange-traded fund (ETF) in the U.S. – now called the SPDR S&P 500 – will celebrate its 20th anniversary. Exchange-traded products (ETPs), including both exchange-traded funds and exchange-traded notes (ETNs), offer a multitude of benefits to investors including lower fees and direct exposure to a wide range of asset classes from the staple must-haves for any portfolio to the exotic realms of emerging markets currencies and buy-write option strategies. While many investors have already taken up ETFs for their portfolio we expect this trend will continue in the months and years ahead.
Exchange traded products have grown tremendously over the two decades since SPDR’s maiden voyage. There are now around 1,436 products in total, comprising $1.3 trillion in assets. This is still a far cry from the estimated $10 trillion that is invested in mutual funds. But investors are showing an increasing propensity to do what we at MVCM have been doing some time now – using ETPs are a core component of a prudently diversified asset allocation strategy.
The evidence that has accumulated over time – and to the core feature of our approach to investment management – shows that the most important decision investors can make is around strategic asset allocation, and ETPs serve a valuable role here. For one, you don’t have to worry about your fund manager straying from the stated strategy in search of better returns. Style drift, as this is called, is not helpful from an asset allocation standpoint. With ETPs you know what you are getting – large cap value equity, total return bonds or what have you. Lately, ETFs and ETNs have been launched that offer even more specific objectives such as high dividend yields, lower volatility and many alternative investment options, allowing advisors to diversify across a very broad and deep range of asset classes.
Another area where ETPs are likely to grow is in 401(k) plans. New regulations put in place earlier this year require more transparent fee disclosure to retirement plan participants, including the fees related to the plans’ investment choices. The generally lower fee structure of ETFs will likely attract more plan sponsors and managers to utilizing these vehicles in greater number going forward.
So let us all wish exchange-traded products a very happy 20th and appreciate the value they have brought to the world of investing. We expect the next two decades will be promising indeed for their continued growth.
Now that the election is over and done with, US investors have turned their focus once again to the looming fiscal cliff and deepening recession in Europe – and their reaction has been anything but kind. At close on Wednesday, the Dow Jones Industrial average was down a whopping 313 points, once again bringing it below the 1300 mark.
Much of this negative reaction was brought on by comments by European Central Bank (ECB) President Mario Draghi, who discussed concerns about Germany, the Eurozone’s biggest economy. A 1.8%month-on-month fall in industrial production as well as a 3.3% decline in factory orders have resulted in the European Commission reducing Germany’s 2013 growth forecast by around half – it is now expected to grow 0.8% next year rather than the previous estimate of 1.7%.
Most disconcerting about these numbers, as Draghi stated, is that “Germany has so far been largely insulated from some of the difficulties elsewhere in the euro area”. However, these new reports and growth estimates suggest that the Eurozone’s largest economy is not immune to the problems that have been plaguing other member countries for quite some time now; most notably “deplorably high” unemployment , a weak economic outlook and a an ongoing three year long debt crisis.
The European Commission’s 2013 growth prediction for the rest of the Eurozone countries is not any better – a paltry 0.4% growth is expected, barely above recession territory.
But investors shouldn’t necessarily panic – this sentiment is vastly different from the lead-up to Draghi’s star turn in late July when he succeeded in gaining approval for the ECB to conduct sovereign bond-buying programs intended to reduce market volatility and borrowing costs for struggling Eurozone countries. The best advice for investors in our opinion is to stay disciplined and watch how the various economic concerns in both the US and Eurozone continue to play out. If we can get through the next couple months without a worst-case scenario playing out it could lead into opportunities for growth in 2013.
With less than one month to go until Election Day the political narratives are in full swing. Dead-center in the crosshairs of the economic debate is the subject of taxes: what will happen to the Bush-era rates on income and capital gains, what about the payroll tax, Medicare contribution taxes and all the rest that no doubt have the CPAs and tax attorneys of the world busily at work helping their clients make sense of what might happen. The questions that tend to come our way, as investment advisors, is how changes in tax policy may impact investment portfolios and what action, if any, one should take.
Wagging the Dog
When it comes to decisions around taxes the fundamental tenet of our beliefs is this: taxes are the tail, investment policy is the dog. In other words, your investment policy should drive tax decisions; tax decisions, or reactions to changes in tax policies, should not drive investment policy. The tail should not wag the dog. If you have a taxable, non-qualified portfolio then when evaluating two alternative approaches, all else being equal it makes sense to opt for the one that is more tax-efficient. But first make sure that all else is equal. As in: if both alternatives are equally prudent in view of my long-term return objectives, risk tolerance and other relevant considerations, and alternative A is more tax-efficient than alternative B, then alternative A is the right choice. That’s how to make investment decisions around taxes. Pay attention to those operands “if, and, then” – because they matter.
Uncertainties and Probabilities
Here’s how not to make investment decisions around taxes: make decisions today, irrespective of whether they are in line with your investment policy, because of tax policy changes that might happen tomorrow. Right now there is a great amount of uncertainty. We don’t know who is going to win the presidential election, who will be in control of the Senate or the House of Representatives, or what margin of control the majority parties have to work with, or any number of other variables that will influence how tax policies are fashioned. We don’t know what dynamics will be at play as opposing sides try (or not) to reconcile their differences to avoid the “fiscal cliff”. The possible outcome generating much of the debate among investors about what to do is the long term capital gains tax, which could go back up to 20% from the 15% level that was established as part of the Bush cuts in 2003.
In our opinion there is a logical way to address this question, which is simply this: If your investment policy doesn’t contemplate any necessary asset sales that would trigger a long term capital gains tax event, don’t create asset sale mandates just to “lock in” a 15% rate. However if, in the context of your overall asset planning and income generating plans over the next twelve months or so, you identify asset sales that are likely to take place, and you are relatively indifferent as to the timing now or one year from now, then perhaps it makes sense to think about selling when you are certain about what the capital gains rate is rather than when you don’t know what it will be. That’s prudent, and that is wholly in line with investment policy dictating tax actions – the dog wagging the tail, as it should be.
Election season brings out the snake-oil salesmen and Chicken Littles of the world, running around with hyperventilating headlines about how the sky is falling and you have to act now. Nonsense. Successful investors are the ones who ignore the breathless hype and stay disciplined and patient.