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Positive Growth In Early Q4, 2010
After a choppy summer, positive developments emerged to lift equity markets during early Q4/10. This improvement validated our previously expressed view of no double-dip recession, but rather a continuing digestive process from 2009’s large gains.
Most notably in the US, GDP growth resumed, manufacturing improved, the service sector strengthened, and exports increased. Additionally, the Federal Reserve announced the launch of a new easing program, which temporarily rallied the markets due to its stimulative effects. Overseas, global growth continued to strengthen, especially in emerging markets.
It’s Still Choppy and Volatile
Despite the positives, markets remain highly volatile, with major trends continuing to reverse over short time periods. For example, the US dollar rose steadily in Q2, declined rapidly in Q3, and began rising again in Q4.
This constant trend change created significant volatility in commodities, currencies, foreign equities, and fixed income funds, regardless of the fundamental values.
Another set of trend reversals occurred when fears of credit default in Greece emerged in Q2, followed by a settling period after the EU bailout of Q3, only to be reignited by a crisis and bailout in Ireland during Q4.
This trend change drove volatility in many assets as well, despite little changes in core valuations. Volatility is also being stimulated by the composition change of market participants. While conviction-less institutional high-frequency day trading has been significantly on the rise, we have yet to see the return of the buy-and-hold retail investor after their mass exodus during the 2007-2009 bear market.
Where Have All The Retail Investors Gone?
For the most part, the retail investor bought heavily at the peak of 2007, and sold into the depths of the bear market through early 2009, missing out on the massive rebound in late 2009.
As was the case during the Great Depression, it is possible that a large number of these investors have been affected for the long term, and may not return to the markets for a while, if ever.
As measured in fund flows, retail investor participation in the equity market is incredibly low relative to historical averages. This combination of reduced long-term buy-and-hold retail investing and increased institutional day trading, has contributed to the current market volatility that lacks direction.
As a side note, the majority of fund flows by retail investors have been into fixed income funds, which have far outperformed equities in the last decade.
However, we believe that the current retail investor’s chasing of the past decade’s performance will end in tears. A similar approach was taken by investors chasing equity performance from the 90’s during the 2000’s, with little to show ten years later.
Choosing investments based on backward looking results is a “strategy” that has continually failed throughout history …and yet, it is the “strategy” that most retail investors follow, because it feels right and others are doing it. Excess 10-year returns tend to lead to overvaluation, while sub-par 10-year returns tend to lead to undervaluation and opportunity.
Despite the resurgence of fear in country-specific credit markets, financial conditions are continuing to improve as measured by the Bloomberg Financial Conditions Index and TED spread.
Additionally, asset classes are behaving in an uncorrelated manner as they should, which means the market is functioning properly. This evidence points to a continued healing process, albeit in a protracted and volatile manner that our media likes to pitch as a daily crisis because it captures audience attention.
More specifically, we believe that there are enough positives to support an upward move in equities through the year end and into the first two quarters of 2011.
Thereafter, many questions remain in regards to continued growth, reduction of budget deficits, and potential distortions from the massive government stimulus provided. This evolving backdrop continues to lend itself to more active investment strategies versus a simple buy-and-hold approach.
Unfortunately, we do not see the employment picture improving that dramatically going forward, which is difficult for many Americans. However, owners of assets, and investors in markets, should be able to profit as inflation and private growth eventually kick in.