Is the Strong Start Indicative for the Remainder of 2012?

U.S. stock markets started off the year very strong with the S&P 500 returning 12.59% for the first quarter of 2012. On the other hand the main bond benchmark index was up only 0.3% for the quarter. This is the opposite of last year where bonds outperformed stocks. It would seem, with stocks going up and bonds underperforming that investors are gaining more confidence in the stock market and things are starting to normalize again. The strong start, however, has caused the “herd” to become complacent, which is a major concern going forward as there are a lot of red flags of which investors need to be aware.

Decoupling of U.S. Markets and International Markets

Overseas markets will usually outperform U.S. markets during a strong bull market. Currently, however, we are seeing a divergence from this historical pattern. Some foreign markets of the Euro zone countries like Spain, France and Italy (All three are major economies) are actually approaching their respective lows of their last bear markets in 2008-2009 (see charts below). Conversely, U.S. markets are approaching their last bull market highs of 2007. This trend divergence known as decoupling (a breaking apart of two things that normally trend together) rarely continues for an extended period of time and eventually reverts to trending in the same direction, which I believe will be down.

Complacency (lack of fear)

The “herd” or average investor has become complacent as U.S. markets approach their all time high and popular stocks such as Apple surpassing all time highs. When someone is complacent in the stock market they do not fear that it will go down. When that is the case the “herd” will put most of their money in stocks causing a further upside movement with the extra demand. At some point, however, the “herd” runs out of new money to invest in the market and now they have become a large group of potential sellers. Simultaneously, as the herd is in this euphoric mind set and buying stocks after they have already gone up significantly, the “smart money” is using this extra demand to sell their positions. Once the herd has bought just about all they can, then the market runs out of new buyers which sets off a chain reaction of events usually causing a sharp down turn. As stocks start to fall the herd realizes they have made a bad decision and they start to sell, causing prices to go lower creating more fear. This snowball effect eventually leads to the herd “throwing in the towel” and selling all of their positions also known as capitulation at which point the market usually bottoms as the smart money who sold to the herd at the top of the market now start to buy from the herd who has sold out at the low. This symbiotic dynamic (the masses making wrong decisions and the smart money capitalizing on the opportunity) is a natural law prevalent in the market whereby prudency dictates that we invest contrary to the herd. At the end of the first quarter, the primary measurement of fear and complacency, the CBOE volatility index (VIX), measured the highest level of complacency since 2007. The last time the market was this euphoric was at the peak of the housing and stock market (see below).

Update on the Secular Bear
In the first quarter I discussed the current secular bear market, here is a quick update. We currently believe the upside is limited while the potential downside could be severe. In the chart below you will see that the highs of the S&P 500 for year 2000 and 2007 were approximately 1550 (see horizontal red line of resistance). The recent high in the S&P 500 was about 1430, just under 8% from the highs of 2000 and 2007. From a technical perspective it will be very difficult to surpass those highs. On the other hand the lows of 2002 and 2009 were around 750 (see horizontal green line of support). That means the long-term potential downside is around 40%. The limited upside and the extended potential downside increases the need for risk management. We have managed the portfolio’s quite defensively because of this large disparity of increased risk of loss.

Bond Market Update

As of March 31st corporate and high yield bonds were strong and U.S. Government bonds were weak. This is typical in a market that is rallying. Since the end of the 1st quarter, as the market has started to rollover and head lower, the bond strength has reversed. Safe haven bonds like U.S. Government bonds have gone up while the more risky corporate and treasury bonds have decreased. Over the last 14 months until this past February, Muni bonds were particularly strong. While we have benefitted from the rise in Muni bond prices, now is the time to be cautious, as sharp corrections can occur after big runs. Consequently we have shied away from the riskier long-term Muni bond holdings in favor of the safer short and intermediate term Muni bonds. Our bond portfolios, as a whole, are light on risky bonds and heavily invested in more core and U.S. Government bonds as we anticipate a more volatile market in the near future.

As such, Allgen’s focus in the second quarter of 2012 will be on preserving portfolio values by managing all of the above mentioned risk, holding high levels of cash, safe haven assets and non-cyclical assets when appropriate in order to avoid major losses when markets drop and conversely positioning assets for what we believe will be a strong post secular bear market run. Historically, the markets have produced double digit returns for an extended time period following secular bear markets. As such, proper positioning and timing of market reintegration will prove to be of great value for our client’s portfolios into the extended future.

Although these types of markets are very challenging, history has shown that those who persevere come out on the other side stronger and well positioned for the prosperous times that follow. We are excited to continue to overcome such market environment challenges with diligent market monitoring, positioning and purposeful client communication.

Have a great spring time!

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Written by:
Jason Martin, CFP®, CMT
Chief Investment Officer
Allgen Financial Services, Inc.