I wanted to share our current view on the investment landscape and our approach to the financial markets. We say “markets” since there are many markets depending on the asset class. We are tactical in our investment approach and adhere to a trend-following philosophy. We try to rotate our positions into market strength and stay there until it switches. Switches can lead into a sector or style rotation or into cash if conditions deteriorate. Generally, our average holding time on a tactical position is about six weeks. We are also a big believer in market seasonality with the bulk of market gains coming from fall into the spring. Given that, history is a guide and does not guarantee it works every year. But we consider it to be like trade winds to those sailing the seas. Trade winds in the sailing world are the prevailing pattern of easternly surface winds. Historically, the trade winds have been used by captains of sailing ships to cross the world’s oceans for centuries. The captain of the ship seeks a course along which the winds can be expected to blow in the direction of travel. Likewise, one has to be aware of the investment environment he is navigating.
Tis the holiday season and bulls are hoping that Santa Claus will make for a Merry Christmas and Happy New Year with an end of year rally. All eyes will be on end of year performance with the failure of Santa to appear certain to precede a bear market. This end of year rally tends to occur the last five days of the year and the first few days of the new year.
2010 is closing out the year in typical seasonal patterns with a strong end of year rally which started in early September followed by some profit taking and tax loss selling in November. Currently, the rally has been broad based for equities, especially domestic equities, and a little less volatile for a “W” or “wolf-like” market that we have experienced in 2010. Several factors have contributed to the strong close including historically strong months of November – January, and anticipation of the historically strong performance in the pre-election year (2011) of the four year presidential cycle. Also, the market appears to have anticipated the election results of Republicans retaking the House and closing the gap in the Senate – giving rise to Washington grid lock. Add to this the recent anticipation that the Bush Tax Cuts will be extended for another two years for all taxpayers on the back of the recent Obama / Republican tax deal announced this past week. This tax deal also has a 2% payroll tax holiday for all employees in 2011 and the reduction of the estate tax to 35% with a $5 million exclusion per person. It appears that a vote in the Senate and the House will happen this week.
Our thinking is that if it doesn’t pass here in December with the current lame duck congress, it would pass in 2011 with a stronger Republican representation. One would think the Democrats would get a worse deal on revote of this in 2011. Many economists and investment houses have bumped their growth forecasts with the extension of the Bush Tax cuts set to expire at the end of 2010 and a continuation of tax rates for dividend and capital gains.
No changes are expected from the Fed this week although one has to wonder what the inside conversation will be with the rocket change in interest rates since QE2 was officially announced at their November meeting. Since that time, interest rates have shot up, calling into question whether the Fed has enough ammo to bring rates back down in the face of Bond Guru Bill Gross calling the end to the 30 year bull market in bonds. For the first time in November, the largest mutual fund, Pimco Total Return, had net cash outflows following Gross’s comments on the end of the bond bull market and floor on interest rates.
One of the things we have warmed our investors during the fourth quarter was the risk of bond with rates touching historic lows in October – 10 year treasury at 2.3% (10/8). Currently, yields on the 10 year treasury have shot up to 3.3 in the last week, wiping out gains for those investors that purchased these bonds in the last two months.
On the earnings front, we will start another earning season in January and expectations are that we will have another solid round of earnings, especially in light of the stronger than expected retail sales and Christmas shopping. The warning here is that investors have bought prior to earning announcements and sold on the earning announcements.
In our investment portfolios, we like growth styles (small, mid, and large in that order), small cap value, energy, technology and semi-conductors, and precious metals. In terms of domestic versus international, the domestic has been much stronger as a flight to safety in the U.S. dollar and away from the European markets due to Euro country debt concerns and the spreading contagion – a crisis in slow motion which investors have witnessed here in the U.S. during the financial crisis. Precious metals and commodities continue to be strong with silver and gold climbing higher.
The international markets are really split in two with the developed markets and the emerging markets. We like the emerging markets better since they will have higher growth rates than developed markets and they have lower debt problems. Developed markets such as the European countries are dogged by their debt problems and the spreading contagion. Austerity programs will result in budget cuts and less spending to get their fiscal house in order. Current positions include Emerging Markets (EEM), Asia Small Cap (MSMLX), MSCI EAFE Small Cap (SCZ), Brazil Small Cap (BRF), Chile (ECH), Peru (EPU), Mexico (EWW), Canada (EWC), and Taiwan (EWT).
Certainly, the weakness in the income market is interest rate sensitive, especially treasuries on the rise in rates. We continue to like high-yield debt although it has moved sideways over the past few weeks. We believe this will be the sweet spot of the income market in 2011. We also like the preferreds, real estate preferreds, asset backed, and attracted to the yield on the MLP ETF (AMLP).
The lump of coal this year-end will go to bond investors, especially those in the zero coupon and the muni market. Rates have shot up from the lows of October. The anticipated extension of the tax cuts along with planned termination of the Build America Bond program means these bonds are less favorable and there will be more supply within the muni market.
For now, we are hoping that Santa Claus will make his annual end of year visit with more presents than lumps of coal. Merry Christmas & Happy New Year.