Markets Break to the Upside

US and global equity markets rose nicely during Q4, breaking the range-bound trading ceiling earlier in the year, despite mid-year fears of a double dip recession, and media doomsday reporting of such off-the-wall negative indicators like the Hindenburg Omen.

US equity markets proved the strongest worldwide, especially as Congress passed a tax-cut extension that boosted confidence, and the US dollar strengthened.

Emerging market equities continued to perform, but at a more subdued pace as many countries took measures to cool off their overheating economies.

In fixed income, U.S. treasuries and municipal bonds took a beating, as interest rates rose on improving economic reports (e.g. positive job growth figures).

While markets delivered a modest return, investor behavior was once again a problem during Q4 and all of 2010.

Many market participants sold into the 20% summer decline, and once again into the 5% November correction, being humbled each time the market rebounded.

While it is prudent to hedge risk, many investors lost their longer-term focus, finishing the year with negligible or even negative returns.

Of course, this is nothing new (see chart below).

Pattern of Investor Cash Levels vs. S&P 500 Returns (2000 – 2010)

Once again, the masses of investors were selling equities while the market was rallying, and only starting to buy them back very late in the year after the rally had been completed.

The root cause of such behavior lies within something we have discussed many times in our newsletters: the majority of investors do not like to invest when economic and media headlines appear negative, and yet that is oftentimes when equity markets perform best.

Delivering Real Returns

Client portfolios were positioned in line with our thesis that US markets would break out to the upside from their sideways trading range during the summer.

Additionally, we believed that emerging markets would outperform developed markets due to continued secular strength and better financial health.

On the fixed income side, we over-weighted high-yield fixed income, while shorting US treasuries on expected further recovery in the economy.

Q: What worked?

Our expected scenario in the US played out nicely, as the market broke to the upside during Q4.

Consequently, LGA clients participated in market gains as we held onto positions during temporary declines.

Specifically:

  • We held onto investments when many others sold into the 5% correction during November. We believed that the rally would ultimately continue and were rewarded for holding on.
  • One of our deep value investments (ticker: DRYS) that underperformed last quarter, delivered a 54% return during Q4.
  • Our short treasuries position (ticker: TBT) began to rebound after trailing last quarter.
  • One of our slower and steadier, range-bound real estate positions (ticker: IRET) recovered and paid nice dividends

Additionally, our high-yield fixed income bonds continued to issue robust dividends, while our diversifiers (long/short funds, currencies, merger-arbitrage, absolute return, etc) delivered a solid 4-6% return for the quarter.

Q: What didn’t work?

For aggressive clients, almost all the investments we held delivered positive returns.  However, our assumption that emerging markets would outpace US markets was incorrect, with US equity posting the highest returns.

For conservative clients, we significantly reduced our blended bond fund exposure based on our models indicating overvaluation.  When US treasuries declined significantly during Q4, this reduction proved a wise move.  However, we still had some exposure to this asset class, and consequently saw some declines in value as well.

For all portfolios, we had significantly reduced our foreign developed market holdings, which proved fortuitous when the European debt crisis hit again.  However, this small position did exhibit some declines in portfolios.

Finally, our natural gas position continued to decline during the quarter, and we decided to stem the decline by swapping the commodity for natural gas companies.

Net Results

Our diversified portfolios delivered positive returns for Q4.

More importantly, clients again stuck with, and in many cases added to, their investments during the 5% correction in November.

Consequently, they will be pleased to find higher account balances, while many others sold into the decline for permanent losses, or clung to low-yielding assets such as cash.

Market Strength For the New Year

We believe that equity markets will move higher through the first half of 2011, albeit with the potential for 3-5% corrections along the way.

Economic indicators are starting to post repeatedly stronger gains, and specific improvements in employment and consumer demand tend to have a virtuous effect as they spur increased business activity, and consequently more hiring.

We are beginning to see signs of emerging markets overheating with higher inflation rates, especially amongst food commodities.

Consequently, these markets may have greater corrections on government actions to cool off growth.

However, emerging markets remain in a secular growth trend which we believe will continue after minor corrections and consolidation (in the short-term, they may continue to trail the US equity markets a bit).

In fixed income, we believe there will be a tug of war between economic strength that drives rising interest rates, along with Fed quantitative easing through May, which aims to lower rates.

Specifically, we have shifted some exposure from emerging markets equities back to US equities based on short-term factors discussed above.

In fixed income, we believe the strengthening economy will benefit our short US Treasuries and long high-yield debt positions.

In commodities, we made minor shifts out of natural gas and into gas and oil exploration companies based on our belief that equities of companies will rise more strongly.

Finally, we are maintaining our positions with diversifiers (long/short funds, managed futures, currencies, merger-arbitrage, etc.) in case we are wrong in our beliefs and the markets turn down once again.