Tuesday, October 9, 2012

Third Quarter Report: Should You Be Selling?

Yesterday the IMF downgraded their assessment of the global economic outlook.

This represents their second downgrade in recent months, and understandably has caused many of my clients to question whether now is the time to be reducing or exiting equity positions.

My response so far is no.

I believe that the most likely policy response from the world's central banks will be more fiscal and monetary stimulus, some of which will doubtlessly flow into the equity markets.

I discuss this more fully in my third quarter letter to institutional clients:

The global tsunami of liquidity unleashed by the world’s central banks spurred market gains in the third quarter of 2012.

The S&P 500 produced a total return of +6.4% for the three months ending September 30, 2012.  Despite the backdrop of sluggish economic growth, the market has given investors a total return of over +30% for the last 12 months.

Besides easy monetary policy, stocks have been helped by record low interest rates.  The Federal Reserve announced in the third quarter that it intends to keep interest rates near 0% until at least the middle of 2015.  The Fed’s intention is to try to pry the trillions of savings now parked in cash reserves into riskier assets such as stocks, and so far at least it has been successful.

As is often the case, however, the gains in the market have been uneven across sectors. 

Telecommunication stocks have been the best performing sector year-to-date due primarily to their high dividend yields.  Technology stocks – lead by Apple, which is up an eye-popping +65% in 2012 – have been the second best performing sector so far this year. Lagging sectors, meanwhile, have been utilities (+1% YTD) and energy (+6% YTD).

The market valuation at current levels is roughly in-line with historic price/earnings levels.  However, compared to other investable assets such as bonds, the relative attraction of stocks stands at historically high levels, which offers the prospect of further gains ahead.  

Our focus for the remaining months of 2012 will be primarily on two areas.  First, stocks that have lagged the broader market averages this year (e.g. energy; industrials; utilities) could present an opportunity.  Second, while the broader economy has struggled, housing and auto sales have been brisk. Home sales are picking up from the 2009 lows, and many companies will benefit.  In addition, auto sales are now running at 4-year highs, and auto companies and related stocks should also do well.

At the same time, there remain several areas of concern.  Europe continues to struggle to find a workable solution to its euro troubles.  In Washington, the prospect of a fiscal cliff resulting from political gridlock could reduce growth forecasts for 2013, and hurt equity market performance as we approach the end of year.  Finally, corporate leaders have been quite vocal that many parts of their global businesses continue to be soft, particularly in the emerging markets.

We remain cautiously optimistic for stocks for the rest of the year.