Thursday, January 7, 2010

Review of the Fourth Quarter and Year 2009

Amid further evidence of global economic recovery, many of the trends dominating financial markets since early March were extended through the 4th quarter. The U.S. and international stock markets rose, including gains of 5.5% in the Standard & Poor’s 500 Index, 6.7% in the EEM Emerging Markets ETF, and 1.1% in the EFA Developed Countries ETF. Most commodity prices continued their ascent, including a hike from $70.61/barrel to $79.36/barrel in the price of oil and a pop from $996/ounce to $1,100/ounce in the price of gold. The yield rose (and price fell) on the benchmark 10-year U.S. Treasury note and the interest rate on most money-market funds remained at or below 1.0%. A notable new development was a December rally in the dollar against major currencies, which may be attributed to surprisingly positive U.S. economic data suggesting that the recovery might be accelerating. An immediate consequence of the dollar’s bounce was to reverse partially the upward surge in commodity prices, and in particular gold, and to reduce the relative attractiveness of international investments.

Despite an early year plunge in global equity markets, 2009 will be long remembered for the dramatic and unprecedented bull market that commenced in early March and continued without a significant correction for the remainder of the year. For the S&P 500 Index, this rally measured 64.8% and, in the process, the Index offset its -25.1% decline earlier in the year and left a satisfying 23.5% gain for 2009 as a whole. Many investors failed to match the performance of this standard benchmark, and some investors participated minimally or not at all. The Investment Company Institute’s (ICI) reports to the Federal Reserve show that for 2009 through November there was a net outflow of $4.127 billion from stock mutual funds and that as of December 29 there was still $3.293 trillion tucked away in low-yielding money market funds. According to Hedge Fund Research, the average hedge fund returned 19% to investors in 2009. Morningstar’s data on mutual fund performance also indicates that few fund managers shifted strategy in early 2009, with the result that many of the best performers in 2008 were among the worst performers in 2009, and vice versa.

Some of the keys to successful equity investing in 2009 were:

• The old Wall Street adage don’t fight the Fed was especially relevant in 2009. Governments and central banks around the world initiated massive and unprecedented stimulus packages in late 2008 and early 2009, yet stock markets in January and February suffered a cascade of selling culminating in a brutal capitulation in early March. Investors who ignored the pervasive gloom and doom and exercised patience in waiting for the beneficial impact of the stimulus policies were rewarded.

It’s always darkest before the dawn. We cannot remember a time when it was more pitch black than in early March, when the S&P 500 Index was off 58% from its October 2007 high. Nevertheless, in late March a consensus of economists predicted an economic recovery in late 2009 and 2010 (see our April 1 Outlook). Some investors understood that the stock market is an anticipatory mechanism, which historically has bottomed about 6 months prior to the end of past recessions, and increased their commitment to equities in the 2nd quarter. They were richly rewarded.

• In our view, equity strategies based on a 6-12 month horizon are more often correct and easier to execute successfully than short-term, market-timing strategies. From late March through the end of the year the financial media hosted a parade of gurus who incessantly questioned the sustainability of the rally and promoted the view that a sharp correction was inevitable and immanent. On the other hand, we pointed out in our October 1 Outlook that successful market timing requires not one but two correct decisions, and that it is especially difficult to execute in the midst of an upward moving market supported by economic fundamentals. There never was a correction greater than 7% in the S&P 500 Index, and many market-timer investors either bought back their shares at higher prices or ended up sitting on the sidelines as the bull market rolled on.

In a bull market, be bullish. There was a widespread belief in the early stages of the rally that a majority of investors, shocked and damaged by the devastating bear market, would favor defensive blue chip stocks in any market rally. To the contrary. Historical evidence is that following recessions and bear markets, those equity investors still active in the markets are driven by bargain opportunities and/or the promise of cyclically driven growth. This was true in 2009. The top-performing industry sectors in the S&P 500 Index were the economy sensitive materials (+43.3%), consumer discretion (+38.3%), information technology (+35.5%), and energy (+27.4%). On the lower end of the ladder were the defensive sectors of consumer staples (+13.8%), health care (+13.1%), utilities (+6.4%), and telecommunications (+2.4%). The big and presumably safer Dow Industrials (+18.8%) lagged.

Investors need to be willing to take a global perspective. By the 2nd quarter it was already evident that the leading emerging economies (China, India, and Brazil) were weathering the global recession far better than the leading developed countries (U.S., Europe, and Japan) and also would provide stronger and more assured growth in an eventual global economic recovery. It was thereby reasonable, and correct, to expect these emerging economy stock markets to outperform significantly the developed country markets (see our April 1 Outlook). In 2009 the EEM Emerging Markets ETF soared 66.2%, whereas the EFA Developed Countries ETF rose 23.2%.

In the 2009 bond market, it was a good year for corporate bonds, and especially low-rated “junk” bonds, but a miserable year for investors in U.S. Treasury securities. Going into 2009, when the recession storms were howling, fears of a multiyear deflation were widespread, and the global credit crisis threatened almost all leading financial institutions, money flowed into super safe U.S. Government securities. The resulting decline in yields was also a consequence of unprecedented measures taken by the Federal Reserve to stabilize economic and credit conditions. As of the last trading day of 2008, 90-day Treasury bills yielded a paltry 8 basis points, 2-year Treasury notes yielded 77 basis points, and the benchmark 10-year Treasury note yielded a near record low 2.21%. We pointed out in our January 6, 2009 Outlook that the yields on shorter term bills and notes were too low to have investment appeal, and the yields on longer maturity Treasury securities would likely rise (and prices fall) when the recovery we anticipated later in 2009 set in; we recommended high quality, intermediate-term corporate bonds. As it turned out, U.S. Treasury securities suffered their worst total return year since 1978, as indicated by the 3.84% yield on the 10-year note at the end of 2009. In contrast, yields declined (and prices rose) for most corporate bonds as economic recovery improved corporate credit and diminished concerns for maximum safety.

Among the major beneficiaries of global economic recovery in 2009 were commodity prices, which also surged in response to a massive decline in the dollar from early March to the end of November. For the year as a whole, the commodity price index (CRB) jumped 23.5%, which included a 77.9% pop in the price of oil (from $44.6/barrel to $79.36/barrel) and a 26.5% rise in gold (from $869.7/ounce to $1100.0/ounce).

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