Q2 Markets: Don't Expect Smooth Sailing

by: Russ Koesterich, CFA

After a disappointing, frustrating and, at times, terrifying 2011, patient investors were rewarded with a stellar start to 2012. In the first quarter, equity markets banked a performance that would have been respectable for the full year. Developed markets gained nearly 11%, while emerging markets advanced more than 13%. However, equity markets have lost some steam in recent days, and now many investors are wondering if there's anything to look forward to in the second quarter.

The good news is that even after the rally, valuations still appear reasonable. Developed markets are currently trading at around 14x earnings, no longer a screaming bargain but below historic averages. Emerging markets, meanwhile, are even cheaper, trading at less than 12x trailing earnings. In addition, inflationary pressures remain well contained and while last Friday's disappointing employment report reminded everyone that the recovery will continue to be slow and uneven, both the US and global economies are stabilizing.

That said, I don't expect markets in the second quarter to be all smooth sailing. While markets can still move higher, gains are likely to be predicated on earnings growth, which in turn will depend on further improvement in the global economy. And even if the economy continues to stabilize, we're unlikely to see another round of quantitative easing until at least July as the Fed's Operation Twist is set to continue through June.

Without the sedative of easier monetary policy, markets are likely to be more volatile. I expect volatility to be in the high teens to low 20s, above the mid-teen levels that characterized the first quarter. In fact, it's probably fair to say that the first quarter rally was more a function of continuing, and arguably intensifying, central bank generosity rather than a reflection of fundamentals experiencing a complete turnaround.

Given this environment, as the second quarter kicks off, investors should consider repositioning their portfolios to access international equity income, prepare for more volatility and shift into investment grade credit.

As I've mentioned before, in an environment of slow growth and more volatility, higher income stocks are more likely to outperform. However, such stocks currently look expensive in the United States, meaning investors may want to cast a wider net to get their dividend exposure through vehicles such as the iShares Dow Jones International Select Dividend Index Fund (NYSEARCA: IDV) and the iShares Emerging Markets Dividend Index Fund (NYSEARCA: DVYE).

In addition, as the market becomes more volatile, investors may want to consider equity funds that employ a minimum volatility methodology that can potentially help insulate portfolios from wild market swings. Such funds typically hold lower-beta stocks than similar, cap-weighted benchmarks and have historically produced higher risk-adjusted returns over the long-term.

Finally, as I wrote earlier this month, while high yield can still offer a good coupon, investment grade debt, accessible through the iShares iBoxx $ Investment Grade Corporate Bond Fund (NYSEARCA: LQD), looks cheaper and should hold up better during a more volatile quarter.

Source: Bloomberg

Disclosure: The author is long LQD and IDV

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