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Stocks Fall, But Some Recovery Late in First Quarter
Despite a strong stock rally in March, most broad U.S. stock indices markets posted significant losses in the first quarter of 2009. The Dow Jones Industrial Average and S&P 500 Index lost about 13% and 12% respectively. In this volatile quarter, stock market swings seemed to reflect investors’ changing views about efforts in Washington to ameliorate the financial crisis. In early January, there had been hopes that the Obama administration would quickly provide a comprehensive solution. These hopes quickly faded, and the stock prices correspondingly sank. The sell-off accelerated amid fears of bank and auto company failures, reaching a low point the first week of March. An abrupt stock market turn-around then occurred, based on favorable reactions to new Treasury and Federal Reserve crisis initiatives. Stock returns for March ultimately were significant – the best one-month stock returns in seven years.
Since late last year, CPIC client portfolios have been defensively positioned to weather the current economic storm. The happy result has been year-to-date portfolio returns in 2009 that fluctuated down only a few percent through the end of March – in contrast to the double-digit losses of the broad stock market indices.
Economic Data Update
Economic data remain weak. Household net worth has fallen about 20% since its peak in mid-2007, banks are still not lending and capacity utilization is at historic lows. Upon revision, U.S. GDP fell at a 6.3% annual rate in fourth quarter 2008. Most forecasts call for more declines over the next few quarters: 7% for the first quarter and 3% the following quarter (both annualized). GDP growth is expected to turn up in the third and fourth quarters, however.
There is a mix of negative and not-quite-so-negative data recently, but nothing to indicate an imminent recovery. Initial claims for unemployment benefits claims are at record levels. The manufacturing sector continues to suffer in the downturn, with industrial production falling –1.4% in February. Year
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over year, industrial production has dropped –11.2%. Forecasts for consumer spending, housing sales and home prices are mixed among economists looking for rebounds in these areas and those expecting further declines.
Current Portfolio Strategy
The current challenge for investors is twofold. The first task is to minimize losses that may occur in stocks if more bad financial data are uncovered. At the same time, yields on cash and money market funds now are so low that the real return after inflation and taxes is negative, so better safe returns are desirable.
How can investors obtain better returns without taking on the risk of stocks? In pursuit of this objective, we have significantly increased positions in bond mutual funds during the past few months. We believe that exposure to certain sectors of fixed income markets represent an incremental, yet compelling risk-adjusted opportunity in the current uncertain economic environment. Distended prices and attractive yields can provide reasonable cushioning if the economic downturn is more protracted than forecast. Conversely, if the economy rebounds faster than current expectations, credit instruments are poised to potentially deliver equity-like returns.
The bond mutual funds selected for CPIC client portfolios were carefully screened for credit quality, volatility characteristics, and duration, as well as for potential return. Most portfolios still maintain an allocation to stocks, although this is a relatively small percentage of each portfolio. The unprecedented economic environment has called for the lowest allocation to stocks ever maintained in CPIC portfolios.
The recent stock market rally is encouraging, but we remain cautious in the near-term. We therefore do not plan to significantly increase equity exposure within the next several weeks. Risk remains high. Current economic data suggest late in the second quarter might be a more opportune time to consider increasing the stock weighting in portfolios, at the earliest.
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