So much for conventional wisdom and the market consensus for 2011. I wrote on my blog early in the year that experts were predicting 2011 will be a "stockpicker's market" where the high correlations among stocks will diminish.
At least so far this year, it seems quite the opposite is the case. From the FT:
Just as it looked like 2011 would see a return to stockpicking and a more discerning approach after the “risk-on, risk-off trade” that dominated much of last year, prices of many asset classes, from equities and bonds to currencies and commodities gyrated in a flight to safety.
And as far as forecasts for market direction, it also seems the consensus was wrong. Although the same FT article argued the following:
Investors had long expected some kind of correction after a bull run in equities that has taken the S&P to more than double its financial crisis level of two years ago.
I recall that those year end forecasts were uniformly bullish. From USA Today -- Experts agree: Get over your fear and get back into stocks:
Five Wall Street heavyweights say it's time for individual investors to shun the perceived safety of bonds — and get over their fear of the U.S. stock market — so they can take advantage of what they predict will be a third straight year of solid gains for stocks in 2011.
It seems that once again market participants underestimated the black swan risk (a term I caught three times in the March 16 FT article). From the always insightful John Kay:
The mark of a first-rate intelligence, Scott Fitzgerald wrote, is the ability to hold contradictory ideas in the mind at the same time and still function. Probabilistic thinking requires us to recognise both that something might happen and that it is unlikely that it will. Because this is difficult, we are always surprised, shocked, and inadequately prepared for extreme events.
Some specific observations on reactions in various sectors of the market:
U.S. Treasury Bonds
The financial press was full of reports over the last couple weeks of the big move out of Treasuries by Bill Gross of PIMCO. Gross' PIMCO Total Return Fund (PTTRX), the world's largest bond fund, has reported it is at 23% cash. It is quite possible the fund held derivative positions betting against Treasury bonds as well.
The black swan turned the bond market in the exact opposite direction as the flight to quality created a big wave of buying of U.S. Treasury bonds.
Looking at bond ETFs: TLT (20 yr + Treasuries) was up 3% as of Wednesday and TLH (10- 20 yr Treasuries) gained around the same amount. Surely, those short Treasury bond futures experienced some large losses.
Global Stock Markets
Looking across the carnage in the world's equity markets, Germany's severe losses strike me as surprising. The Germany ETF (EWG) has fallen 10% compared to -3% for the U.S. over the past few trading days. It's hard for me to see that the damage to the German economy will be commensurate with the damage to its stock markets.
So, a couple hypotheseses to explain the move:
Indexers holding developed market indices like EAFE (ETF: EFA, VEA) looking to reduce their exposure to Japan would need to sell their index positions. This would necessitate selling of all the stocks in the index with Germany and the U.K. having the highest weightings. The large fall in the U.K. market (ETF EWU is down -8%) is likely index related as well.
In the case of Germany, it is also quite possible that Japanese and other global investors, looking to raise cash, would sell their biggest "winners" first. Germany has been the top performing global market recently. This is a well known "syndrome" observed by behavioral economists and institutional investors are hardly immune. Hence, an additional non-economic reason for the sharp fall in German shares.
I think Germany merits a look. I can't believe its economy is affected by the Japanese developments more than the rest of Asia. Yet the ETF for Asia ex-Japan (GMF) is down less than half as much as Germany .
ETFs for Germany (EWG), Japan (EWJ), UK (EWU) and the S&P 500 (SPY)
Corporate and High Yield bonds have taken a hit in the knee jerk flight to quality that has sparked moves to Treasuries and away from other bonds. This is usually a buying opportunity for the credit bonds. Reflecting that flight to quality High yield bonds suffered losses in the ETFs: HYG has lost 2% (JNK had similar losses) and the high yield corporate bond index is at a 7.87% yield vs. 10 year Treasuries yielding 3.2%. That differential is starting to look attractive for buyers of high yield.
Small cap stocks have held up better than large caps as the former are less likely to be dependent on income from outside the U.S.
I think this most recent selloff may put to rest the craze to buy high dividend stocks as part of "investing for income". One invests for total return when investing in equities. Dividends are an important part of that total return, but stocks should not be seen as an income vehicle similar to bonds.
A dividend stock is still at risk to capital loss in the magnitude of other stocks and is certainly not going to diverge from the overally market during a major decline. For example, DTN, an ETF that screens for high dividend stocks, has lost 2.8% in the last 5 trading days, wiping out the value of almost all of its annual dividend of 3.2%. And the drop was right in line with the rest of the U.S. market.
High dividend stocks are not a diversifier away from the rest of the market. The correlation between DTN and the S&P 500 is .96, meaning they move virtually in tandem.
Another area of the stock market where the impact needs to be sorted out is technology. Apparently, there has been damage to the supply chain in this area. But, when things are sorted out, there may be an opportunity for those technology companies not dependent upon Japan. The place to look may be in semiconductor stocks. The semiconductor ETF is XSD.
Of course, it goes without saying that the major concern for all of us should be the human toll in Japan.