April 1, 2010
Greetings Clients & Friends:
The first quarter of 2010 is now in the books and the global capital markets have thus far been trending in the general direction that we expected at the start of the year. We started out with a little upward momentum in the beginning of January, peaked out near 1,140 on the S&P 500 Index, and then began a correction that brought the S&P down to 1,050 by the first week of February.
As I communicated in the Market & Investment Commentary published back in December, much of this broad market decline we had been anticipating for a couple months, and had been raising a little more cash and putting on some hedge positions accordingly. My expectation had been that we would see the equity and corporate bond markets take a breather, but that this wouldn’t knock the capital markets off track from their general upward, recovery trajectory. The “breather” we got in the markets earlier this quarter was induced by a combination of fears related to the debt crises looming in Greece (and spreading to other heavily debt laden countries), uncertainty regarding pending legislation coming out of Washington, and general concern that stocks had gotten ahead of themselves and the broad economy.
While these sovereign debt concerns are somewhat justified, they have been known for months and have been mostly discounted within the global credit markets. Since the February lows the markets have shaken off their concerns about debt issues in Greece, Portugal, Spain, etc. and have re-focused on the global recovery that has emerged. I am not too concerned about the dynamic political winds and posturing in Washington, and I calculate that equities remain relatively attractive versus other asset classes. Therefore, I viewed the January to February pullback as another opportunity to put more capital to work in clients’ accounts, and as a chance to re-allocate into areas that appear well positioned for the next phase of the market recovery.
Short-term Gyrations & Strategic Maneuvers
While I am expecting a continuation of the economic and market recovery over the intermediate-term, with the recent advance in stocks during the month of March we have once again reached a point where markets have gotten ahead of themselves in the short-term. Therefore, as the markets have been trending higher over the last couple weeks we have been scaling back on equity exposure in client accounts across each of the Smith Capital model portfolios. This is more a function of being price and timing sensitive, and thus we have been “trimming around the edges.” As another stock market pullback unfolds then we will most likely seek to add additional capital to attractive, undervalued, economically sensitive sectors. Currently, these tactical movements have resulted in us building up cash levels to a range of 15% to 35% of market value on average, depending on the Smith Capital model portfolio. We also continue to maintain a small % allocation to an inverse ETF, which acts as a hedge against a stock market decline, within Smith Capital growth oriented model portfolios.
In addition to making these tactical allocations driven by equity markets being extended, I have begun making more strategic maneuvers with respect to current exposures to the bond market. Over the last year the corporate and foreign bond markets have performed very well as bonds recovered from their excessively depressed levels. This has been driven by subsiding fears over credit risk, and extremely attractive yields that have been pulling idle cash from the sidelines. At this juncture, I believe most of this movement of cash into the bond market has reached a pinnacle. Furthermore, as recovery continues short-term rates will begin to rise, which in turn will push longer-term rates higher. As the bond market begins to anticipate this, bond prices should tend to weaken. Our strategy is to get out ahead of this weakening trend and reduce overall bond exposure across those Smith Capital model portfolios where we currently have bond positions. We have also been overweighting into shorter duration bonds and bond funds, which tend to exhibit lower sensitivity to increasing interest rates.
While the economic picture is looking brighter every day, there remains a very clear distrust of the broad stock market and capital markets in general. As I mentioned in my last full commentary from December, the level of cash on the sidelines continues to remain stubbornly high. This reveals the magnitude of apprehension among many investors about the sustainability of the current economic recovery and the gains we have experienced in stocks over the last year. I believe this level of distrust and anxiety among investors is itself not sustainable. As short-term rates remain low for much of 2010, and economic growth continues to reassert itself globally, investors will be further enticed out of cash and into areas that provide a comparatively higher return. For this reason I will be inclined to view stock market pullbacks as opportunities to add to attractive positions.
The following charts provide an update on a few key data points with regard to the relative yields of a variety of asset classes, the still high cash levels sitting on the sidelines, and the overall improvement in key economic variables.
I will be publishing a more in-depth quarterly commentary later in April that will present a more detailed outlook for the economy and markets. This commentary will also present a full review of the first quarter performance of each of the Smith Capital model portfolios, along with our current positioning and strategy within each. Thank you sincerely for the continued privilege of serving you and your family.
-Chad Smith