News & Insights
The stock market’s rally since last October has been impressive with the S&P 500 up over 25% since the market lows last fall. The quarter just past represents the best start to the year in over a decade. Investment flows have begun to move into stocks after years of skepticism and risk aversion in which investors clung to investment grade bonds for safety despite their puny yields. The move toward stocks comes after several quarters of improving economic news on employment and continued high profitability of U.S. corporations. Cynicism after months of higher stock prices and improving economics should be difficult to muster but there are good reasons for caution in the next few quarters.
Foremost among these nagging worries is the unhealthy link between Federal Reserve monetary policy and equity prices. The rallies in stock prices since the financial crisis have been disturbingly correlated with announced easing of monetary conditions. The two announced expansions of the Fed’s balance sheet (QE1 and QE2) as well as their increasing of the duration of their now bloated balance sheet (the delightfully named “Operation Twist”) have been catalysts for the powerful rallies that have brought the market to its current levels. These rallies faded when investors feared the end of this extraordinary accommodation. We believe in that shopworn aphorism that one “shouldn’t fight the Fed” but we are repelled at the prospect of “marrying” the Fed and investing like one of Pavlov’s dogs, buying stocks at the sound of the Open Market Committee’s bell.
We have always been more reliant on a reading of corporate profitability to guide investment than we have of monetary policy and there are reasons for investors to dial back expectations of profit growth. Productivity growth, which has been one of the pillars of corporate performance, has been slowing in recent months. This will impact margins and profits. Another source of support for U.S. stocks has been the relatively moderate valuation of the broad market that has prevailed since the financial crisis in 2008. In our view, the recent rally brings the market into fully valued territory, creating a scarcity of bargains.
On a positive note, international markets like Europe, Japan and most emerging markets, which have been roiled by credit crises and slowing exports, are selling at more attractive prices. An increased relative commitment to these markets and a little patience should produce good returns.
Bond prices have dropped (and interest rates have risen) from last year’s unsustainable fear-driven rally. While generally rising interest rates are in the future, it is too early to declare the end of the low rate regime that has persisted since 2008. Corporate bonds, good quality municipals and some “junk” bonds offer a reasonable alternative to treasuries for a portion of a fixed income portfolio.
The Altavista Investment Team- Spring 2012