Wednesday, July 11, 2012

Letter to the Investment Committee - Second Quarter 2012


 
This is what I wrote my institutional clients this quarter:

The global capital markets are having trouble making up their minds.

On one hand, there is tremendous fear and uncertainty about events in the euro zone. 
 
Nervous investors continue to flock to “safe assets” such as U.S. Treasury and German bonds, pushing yield levels on government securities to multi-generational lows.  Higher quality bonds are in many cases offering yields less than the current rate of inflation, yet there is no sign of any slackening in demand.

Meanwhile, in the stock market, risk is being sought and rewarded. 

Lower quality, riskier stocks have charged ahead in 2012, and have left the stocks of higher quality companies far behind.  

According to Merrill Lynch research, only lower quality stocks – those rated B- and below – have outperformed the S&P 500 this year.  The S&P has produced a total return of +9.5% for the first six months of 2012, but higher quality stocks have generally lagged by as much as 400 basis points.  

In short,  while the global government bond markets are signally an almost desperate desire for safety, the global stock markets (particularly in the U.S.) are reflecting a distain for risk, and bidding up the share prices of more leveraged, largely non-dividend paying companies.

This year’s market action has been frustrating for many investors, ourselves included.  Focusing on fundamentals and valuation usually produces strong returns on both an absolute as well as a relative basis, but this has not been the case so far in 2012.

Fundamentals eventually matter in the stock market, and we do not believe this year will be any different.  We expect the performance of higher quality stocks to catch up with the lower quality sector as the rest of 2012 unfolds.

On an absolute basis, the stock market is moderately cheap relative to historic standards.  However, relative to the alternatives – cash and bonds – stocks look very attractive.