(Photo: nickwheeleroz)

Global equity markets accelerated their declines during Q3/11 after the modest declines in Q2/11.  Three main factors spooked investors during Q3:

  • A potential Greek default and its impacts on other European Union countries and banks that hold their sovereign debt
  • Increasingly polarized debate in US politics, specifically around debt reduction approaches (cutting spending v increasing taxes)
  • Continued policy tightening and slowdown in China

While US equity markets declined by nearly 16% over the last six months, European markets slid over 20%, and emerging markets dropped nearly twice the amount as US equities (see Chart I below).

Chart I – Market Returns Over Past Two Quarters

US equity markets tend to decline less than foreign markets during major declines, as they have a greater percentage of defensive industries such as consumer goods, healthcare and utility companies.

The rest of the world has a greater concentration of cyclical companies such as raw material producers and manufacturing.

Additionally, flight to safety reactions can cause a significant rise in the US dollar, as it did during Q3, which temporarily hurts foreign equities (e.g. some currency swings were in the 10-20% range during Q3).

As a result of the recent pullback, global investments are now quite attractively priced based on various valuation metrics (we will discuss this more in other sections of this newsletter).

Additionally, there should be a rapid snap back rally for riskier assets when the news flow becomes less bad (doesn’t need to actually be good…just less bad).

Once the various crises are finally addressed and fear recedes, we will be well into an established rebound.

Q: Why do we Sometimes Underperform at Market Bottoms?

It is not uncommon for our investment strategy to underperform before a major rebound.  We often load up on more volatile investments when they get inexpensive enough that we feel they are attractively priced, expecting an impending rebound.

When we are in a mild correction (more often than not), this strategy works immediately.  However, when we are in a deeper decline, we tend to temporarily go down farther than market benchmarks before we surge above and beyond the entry points post rebound.

Loading Up on Higher Beta

Portfolio Review (Q3/2011)

We entered into Q3 with an expectation that markets would remain range-bound between $1250-1365 on the S&P 500.

Equity models indicated that emerging markets would regain leadership, after temporarily underperforming during the previous three quarters.  In fixed income, we remained over-weight in high-yield bonds.

We also added to our short US treasuries positions on the expectation of either a positive rise in interest rates due to improved economic growth, or a hedge to the downside against a potential debt downgrade.

We also continued operating our relatively new VTM (Volatility Timing Model).

Q: What worked?

The following investments contributed positively:

  • Diversifier funds worked  by either declining less, or in the case of our Absolute-Return Strategy (DSFYX) posted a positive return
  • For the first couple of months of the quarter, our VTM approach contributed modestly

Q: What didn’t work?

Our expectation of range-bound trading was broken when markets turned down dramatically in early August, based on negative policy actions in the US and Europe.

We had incorrectly assumed that politicians would find reasonable solutions rather than sticking to polarized positions.  Consequently, portfolios were not defensive enough.

Specifically, the following positions underperformed:

  • Long-term growth themes (Emerging Markets and Energy Commodities) underperformed as emerging market policy tightening continued in response to inflation fighting.  We expect outperformance should resume shortly.
  • Defying conventional wisdom, our short US Treasuries positions declined when US debt was downgraded in early August.  While the position should have surged, market panic caused global investors to crowd into US dollars and treasuries.  We believe this move to be temporary, and await a snap-back rally soon.
  • Our VTM model was short volatility when the VIX index spiked in early August.  Once VIX hit 40, a very rare event, we purchased more based on the historical pattern that volatility has always receded significantly within 1-2 years maximum of the peak.  While we are nursing a temporary loss on this position, we expect a 150-200% gain from current levels, and a 50% return from the average entry price.

Net Results

Client portfolios differed in their quarterly returns based on their risk profile as well as structure.

Portfolios with greater exposure to emerging markets, short US treasuries position, and VTM model positions temporarily underperformed .

However, these are the same portfolios where we bought back more into these depressed investments, and should see larger gains when the market rallies back as it always does (timing TBD).

As always, we applaud our clients for continuing to save and invest through downturns, allowing us to buy into lows on mass panic, and to generate long-term returns.

New Trading Range, Then Breakout?

Markets appear to have established a new sideways trading range from $1075-1220 on the S&P 500, as investors vacillate between major positives (e.g. strong corporate financials, inexpensive valuations, a rapidly growing global middle class), and ongoing negatives (e.g. EU debt/banking crisis, US debt/deficit issues, Emerging Market policy tightening).

In the US, our economic recovery continues to attempt a handoff from a highly indebted government to the healthier private sector.

This handoff is seen in the most recent September payrolls figures where the private sector added 137K jobs while the government shed 34K jobs.

However, there will be setbacks, such as a net zero jobs created in August (+17K private sector, -17K shed by government), which contribute to market angst.

We expect that economic growth will continue in a positive trajectory, albeit at a more muted pace relative to past recoveries, which has tended to be the case historically after major financial crisis.

Additionally, a new secular bull market (defined as a rise above old highs at $1565 on the S&P500) will require a number of outstanding negatives to be resolved in the near and longer-term:

Despite near-term volatility, we are bullish over the long-term as the massive rise of the global middle-class is setting the stage for incredible growth in equity markets for years to come.

We also believe that the March 2009 low may have marked a generational low in terms of valuations and pricing.