Q1 2012 Market Update

Global equity markets experienced strong performance in the first quarter of 2012 as the relief rally that began in late 2011 continued virtually uninterrupted. In contrast, the U.S. bond market was flat as rates eased up slightly. The total returns for major asset classes are below. 

Asset Class Representative Index

 

 

Q1

 

 

 

 

YTD

 

 

U.S. Equities S&P 500

 

 

12.6%

 

 

 

 

12.6%

 

 

Intl. Equities MSCI EAFE

 

 

10.9%

 

 

 

 

10.9%

 

 

Emerging Markets MSCI Emerging Markets

 

 

14.1%

 

 

 

 

14.1%

 

 

U.S. Bonds Barclays Aggregate Bond

 

 

0.2%

 

 

 

 

0.2%

 

 

What do Investors Want?

This is a question worth revisiting from time to time.

When it is all said and done, we want to own productive assets that will earn a return on capital above that which could be earned in an otherwise safer alternative.

We have many choices as we move our funds from coffee cans, mattresses, and banks into more productive assets. We can loan our money to governments, banks, businesses, or people. We can become owners of real estate or businesses. And, we can do these things either publicly or privately.

Privately, we can loan money or buy a business. This may be the desired choice for some, but with it comes additional risks and complexity. Loans need to be underwritten (just ask the banks how hard this can be) and businesses need to be operated. These additional risks, along with lack of diversification and liquidity, drive most investors to use public markets to access the same investments.

Public Markets – the Good

In the public markets, investors can also loan money or buy a business – in the form of bonds and stocks. The public stock and bond markets bring together ready buyers and sellers in a regulated environment. This assures certain levels of consumer protection and fairness, while bringing liquidity to the process of buying and selling investments.

The net result is magical. Any investor can buy or sell thousands of companies at a time with remarkable ease and efficiency. At a moment’s notice, we can purchase a diversified pool (mutual fund or ETF) of thousands of businesses for the price of a few fancy cups of Starbucks coffee. Think about that. It is truly remarkable.

Conversely, when we want to sell our investments, we will always have a buyer. We may not like the price, but we can turn what would otherwise be an extraordinary illiquid holding into cash on our timetable.

Public Markets – the Bad

Unfortunately, with that liquidity comes visibility into what everyone else is buying and selling – every second of every day. Prices run across the bottom of the TV and are available in the web browser of your choice. Big movements – up or down – become the lead story on the nightly news.

We must suffer through the insult of daily prices to participate in the ownership of publicly traded investments. While it is much healthier and more productive to focus on the value of what we own rather than its quoted price, human nature draws us to follow daily prices movements. When prices go up, we feel good about our investments, and when prices go down we question our strategy. We forget what we own and why.

Public Markets – the Ugly

Sometimes the fear and greed that drives daily price movements builds upon itself leading to major market swings that are not grounded in reality.

The chart below, courtesy of JPMorgan, illustrates the inevitability and severity of those swings.

From 1980 through 2011 the aggregate value of the companies in the S&P 500 increased at a compounded rate of just over 11% per year, yet no single year comes close to that exact performance. In most years, prices wildly overshoot to the upside or the downside. Even in good years there are periods of significant decline (represented by the purple dots).  These intra-year declines, which average -14.5%, are inevitable, and (once again) part of the price we pay for investing through public markets.

Ben Graham, the father of modern day security analysis and Warren Buffett’s mentor, was fond of saying “In the short run, the market is a voting machine, but in the long run it is a weighing machine”

To successfully invest through the unavoidable ups and downs we must:

  • Recognize that corrections are normal in all asset classes (If we are not in one, we may be soon.)
  • Build portfolios that limit our downside to that which we can tolerate.
  • Steel ourselves against these temporary setbacks and keep focused on the long-term goals of our investments.

Conclusion

So far, 2012 has been a great year. The economy seems to be gathering steam, the risk of European contagion has been greatly reduced, and there are (currently) no major political fights in Washington sapping consumer confidence.  However, it will surely be the exception, rather than the rule, if we continue this progress without distraction or interruption though the end of the year.

The important lesson for investors is that returns can't be predicted in advance. We must stay on guard, continue to diversify, and stick to a plan which matches your portfolio with your long-term objectives.

Posted by Jay Healy at 12:48 PM
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