Letter to the Investment Committee - First Quarter 2012

I just finished the my usual quarterly letter for my institutional clients; I have added a couple areas of emphasis:

The stock market enjoyed a strong run in the first quarter of 2012, continuing the rally that began last fall.

The S&P 500 returned +13% for the first three months of the year, making it the best first quarter return for the market since 1998. Financials and technology stocks lead the way, with both sectors increasing by more than +21%.  Last year’s winners – utilities and telecommunications – were the laggards during the quarter.

The question as we start the second quarter is how long the current market rally will continue.  

Skeptics point to last year, when the market also enjoyed a good start to the year only to see the early gains turn into losses by the middle of the summer.  They also note that while the U.S. economy continues to signs of moderate improvement, the rest of the industrial world is mired in recession-like conditions.  China’s economic growth has also clearly slowed, which could also negatively impact the rest of the global economies.

So should you “sell in May and go away” as so many analysts have suggested?

Well, maybe, but there is enough evidence to suggest that the market could have further room to grow.  

Bull markets typically “climb a wall of worry” and that has certainly been the case for the last 6 months.  Flows into domestic equity mutual funds, for example, continue to be negative – the average investor continues to flee the stock market in favor of fixed income, despite the historically low level of interest rates. 

Institutional investors have also continued to reduce their exposure to the U.S. stock market, believing that alternative asset classes such as private equity and hedge funds will provide better returns (despite significant evidence otherwise).

Although the stock market has rallied sharply since last September’s lows, the S&P is still well below its historic highs. At this writing the S&P is slightly above 1400, but it traded as high as 1580 in both 2000 and 2007.  Corporate earnings, meanwhile, continue to grind to record levels, making the overall valuation of the stock market reasonably attractive, especially relative to fixed income alternatives.

There is no question that we will see a market correction at some point in the next few weeks – markets almost never move in one direction, and there is no reason to expect that this time will be any different. 

However, we would view any correction as a chance to possibly add to equity exposure, since we believe that a diversified portfolio of carefully selected stocks will offer the best chance to earn competitive investment returns over the next few years.