After a lackluster 2011 in US equity markets, and a downright ugly year overseas, returns for equity investors returned to the upside in early 2012.

US equities enjoyed a steady upward advance during Q1/2012, with a few daily corrections along the way, as underinvested parties bought on minor dips to get back into the market.

Emerging Markets (EMs) also jumped off to a hot start in January and February, rebounding off of lows from 2011.

While they cooled off in March, EMs still slightly outperformed US equities for the quarter, and they remain highly attractive going forward.

Chart I: Q1/2012 Equity Returns

For more conservative investors, traditional fixed income was disappointing in early 2012, with US treasuries delivering a slightly negative return.

However, high-yield and floating rate corporate bonds continued to advance.  With interest rates at very low levels, and the economy exhibiting increasing strength, treasury rates seem to have nowhere to go but up.

This will continue to erode returns for traditional fixed income investors, as bonds tend to decline as interest rates rise, and their paltry yields will not make up the difference for capital losses.

The multi-decade bull market in fixed income may be nearing an end, and traditional investors, who believe this area to be “safe” and “attractive”, relying on past performance as their guide, will most likely be sorely disappointed in the decade ahead.

In other diversifying sectors, commodities increased modestly, with the exception of gold pulling back in March.

Real estate was also a slight gainer, once dividends were factored in, but these two sectors both trailed the impressive equity returns during Q1 on a relative basis.

Healthy Gains for Portfolios

Portfolio Review (Q1/2012)

Heading into Q1, our indicators suggested that US equity markets were fairly valued, with average returns expected going forward.  Overseas, we anticipated a rebound in Emerging Markets given their significant undervaluation and expected policy easing.  We remained bearish on European equities, given their ongoing debt crisis.

Outside of equities, we stayed overweight high-yield bonds, opened a new position with floating rate corporate bonds, and remained short US treasuries.  We also held commodity mining companies, and high dividend-producing real estate companies.

In our Diversifier asset classes, we continued to hold a number of alternative funds as a substitute for overvalued US Treasuries. We also maintained our short volatility position on expectations of calmer markets in Q1 relative to the high volatility in 2011.

Q: What worked?

The following investments contributed positively:

  • US equities performed nicely, continuing their rapid ascent which began back in late 2011
  • Emerging Markets equities outperformed US equities, albeit they gave up much of that relative return in late March.
  • Our Active Timing Models delivered half of portfolio returns, specifically a short volatility position (ticker: XIV) which surged 88%.
  • Alternative funds and specific fixed income sector picks outperformed the bond market.

Q: What didn’t work?

The following positions underperformed:

  • Our commodities and currency choices delivered positive returns, but slightly less than equities.
  • Outside of our Active Trading models, our alternative fund selections delivered positive returns, but were also slightly less than equities.

Net Results

All client portfolios had strong net returns for the quarter. Active clients (greater than $150K in tradable assets) had more impressive returns than Emerging clients (less than $150K in tradable assets), given the strong quarterly showing from our Active Trading Models.

Such trading models are not appropriate for Emerging clients, as excess trading commissions/costs can erode their benefits when the position size of the trades are too small.

As we help clients grow/save towards their future, they eventually graduate into the Active group, and Active Trading is then added as a more appropriate strategy.

Net-net, 2012 is off to a good start.  However, there is additional room for gain in client portfolios.  While our short volatility position realized much of its potential in Q1, deep undervaluation potential remains in other major investment themes.

In particular, our Emerging Markets and short US Treasuries allocations remain significantly undervalued, and await a catalyst to trigger large gains ahead (timing TBD).

While we will inevitably have our ups and downs, we look forward to continued strong performances in the years ahead, rising from the March 2009 generational lows.

Market Digestion or Indigestion?

Looking Ahead

Markets are at an inflection point with the action moving from a bullish uptrend to a more mixed sideways trend in the last three weeks.

Investors are trying to figure out if the recent market stall is a standard pause before the resumption of gains (called digestion or consolidation), or whether we are about to hit a new rough patch (or what we might call indigestion).

Our own views are that we are in more of a pause mode, with the high possibility of a 4-8% market correction (we are currently down 3 – 4% from mid-March highs).

While most economic and market indicators are solidly bullish, markets are quite a bit overbought, with extremely high technical sentiment levels.

Consequently, a shallow correction would do well to tame the high sentiment levels, without harming the upward trend in the indicators.

We are currently in a neutral to slightly bearish stance for client portfolios, but are closely monitoring our Active Trading Models to decipher the near-term direction.  We will redeploy assets more aggressively if this turns out to be merely a pause.

However, we will position portfolios in an increased defensive posture if our models indicate the potential for a larger decline (e.g. if EU debt crisis, political wrangling in the US, or other issues begin to rear their ugly heads once again).

From an asset selection standpoint, we remain with our themes of overweight Emerging Markets exposure, decent US equity exposure, and little EU exposure.

We also remain short US treasuries, long commodities, and long real estate.  In our Diversifier asset class, we continue to hold alternative funds as insurance in case markets decline rapidly.

Finally, we have begun to lighten up our short volatility positions as the market begins to vacillate, booking some profits from our multiple low entry points in 2011.