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Market Overview & Commentary
Markets typically move in a volatile sideways manner during the second year of recoveries from recessions. Conflicting economic data in the first half of 2010 caused 6-10 week moves in the shapes of a “V” and a “W.” Most recently, the S&P 500 declined 16% from the April highs, after an 80% rally from March ’09 lows.
This suggests a move out of the early bull market recovery and into the expected second-year sideways and range-bound phase, consolidating the massive 2009 gains. These time periods can be highly volatile due to the fits and starts of a handoff from government stimulus to private market demand. However, most recoveries push through this volatile phase after two or three quarters, eventually leading to a renewed bull market.
While our portfolios delivered returns far in excess of market indexes during 2009, 2010 has so far proven to be a more challenging environment. With the majority of traditional investment asset classes once again moving in tandem (a continued thorn in the side to modern portfolio theory,), our newly added diversifiers (long/short funds, merger-arbitrage funds, and managed futures funds) have helped blunt recent declines, especially amongst conservative clients with heavier weightings in diversifiers to reduce volatility.
During the quarter, we missed an opportunity to sell or hedge prior to the recent 16% downturn, with markets turning down sooner than expected. Additionally, we experienced headwinds to our foreign equity holdings due to the European crisis and advancing US dollar. Our undervalued small-cap holdings declined more than the market, as bids dried up on these more illiquid assets. However, we made up for these drags with positive returns in fixed income holdings and currency trading techniques.
We expect fluctuating markets based on conflicting signals. For example, many market influencers point to the recent decline in leading economic indicators as a reason for our recent market pullback, arguing that this is a sign of a coming double-dip recession. However, back-to-back recessions are incredibly rare, and leading indicators tend to peak during second-years of recoveries, while coincident indicators tend to move into the positive, as is currently the case (see Chart I; grey bars represent US recessions since the early 80’s).
CHART I – Forecast of Recovery Ahead
Historically, peaks in leading indicators occur around the same time that coincident indicators start rising, indicating an economic recovery may become more entrenched.Another popular double-dip argument contends debt levels in the US and Europe are unsustainable.
Governments would need to reduce spending and increase taxes, both headwinds to growth. We agree government deficits and debts are too high, but this argument ignores the impact of other growth engines in businesses and consumers, and assumes current government trends will be extrapolated ad infinitum. In fact:
- Business restructuring raised the highest cash-to-debt levels in decades.
- Consumers drastically repaired balance sheets over the last two years; reduced spending, lowered debt, and increased savings.
- Reduced stimulus spending and increased tax revenues due to a rebounding economy improved Government deficits.
Equities are undervalued after recent declines; credit markets signal an easing to the European debt crisis and technical charts signal support at the S&P 500’s 350 day moving average.
Consequently, we expect an early July rebound off of recent lows, and renewed outperformance amongst foreign equities. Furthermore, active trading could make or break returns during this period, so we will attempt to better anticipate major reversals, selling or hedging on strength and buying on weakness. We stay aware of alternative outcomes and adjust accordingly.