Extreme Makeover Wall Street Edition
Sentiment on Wall Street underwent an extreme makeover during the second quarter as investors’ collective mindset shifted dramatically from loss avoidance to capital appreciation. “Overall, the second quarter brought a global sigh of relief that we are evidently not falling into a bottomless pit,” said Stewart Schweitzer, Global Markets Strategist at J.P. Morgan Private Bank.
The distinction between “not losing money” and “making money” cannot be overstated and is easily forgotten, even ignored, when fear runs rampant. The former involves risk aversion behavior while the latter requires risk seeking behavior. Thought of this way, it’s easy to see that these two approaches are opposites that require equally opposite investment strategies to achieve. The trick to reconciling these seemingly mutually exclusive states is as follows (in order):
1. Remain focused on capital appreciation, or making money; in good times and bad. Do not let market turmoil change your mindset lest you lose sight of why you invested in the first place (and your goal!). The portfolio strategy you designed to maximize total rate-of-return over your personal investment time horizon is not changed by short-term events (e.g., economic recession).
2. Distinguish between temporary capital losses & permanent capital losses and reconcile yourself to accepting temporary losses in exchange for higher long-term rates-of-return. This requires the temporary suspension of your average annual rate-of-return expectations during short-term market corrections and more prolonged bear markets. Your long-term average annual rate-of-return expectations remain unchanged.
3. Rebalance your portfolio’s asset allocation as aggressively as your frayed nerves will allow to recover from temporary capital losses and ultimately achieve higher long-term rates-of-return. I acknowledge that the positive impact of rebalancing, diversification, etc. is diminished when virtually every asset class tanks as occurred in 2008. Thankfully, global meltdowns like that one are rare and constitute an exception to the rule. Bottom-line, nothing is 100% fool-proof, 100% of the time.
Did Your Portfolio Participate in the Rally?
Too many investors are content to look at the dollar change in their total portfolio value at the end of a period and, if it’s positive, conclude that they’ve done well. This is too simplistic. Just because the market did well does not guarantee that your portfolio did too. It’s important to know if your portfolio benefited in proportion to the market’s gains. Good for you if it did. However, if it outperformed or underperformed, that could be a call to action.
Consider that emerging market stocks, real estate investment trusts, and financial stocks were decimated by the recession. Share prices collapsed as investors sold them in droves in favor of the perceived safety of U.S. Treasury bonds. Consequently, these assets are under-represented in many private portfolios. “Good riddance,” you might say. Yet emerging markets, REITs and financials led the second quarter rally with gains of +25%, +29% and +35%, respectively. In India alone, the benchmark Sensex Index gained +49% in just 12 weeks. As we’ve seen again & again, yesterday’s laggards often become today’s leaders.
Conversely, the safe haven many investors sought, U.S. Treasury bonds, declined -3% for the quarter, taking its losses for the first half of the year to -4.4%. This is the worst six-month performance in the history of Merrill Lynch’s Treasury Master Index, according to the Wall Street Journal. The benchmark 10-year Treasurys lost as much as -6% on the quarter. Riskier corporate bonds and high-yield “junk” bonds gained +23% for the quarter underscoring investors’ new appetite for risk.
Where Does the Rally Leave Us Now?
Some argue that the market has gotten ahead of itself and is due for a pull-back. Others believe the recent rally is a bear market trap and further declines lie ahead. Even Treasury Secretary Geithner conceded that the current recession isn’t over and a double-dip recession is possible. Looming inflation is an ongoing concern, as is the stability of the U.S. dollar. These are real concerns that cannot be discounted.
My view is that we are at the end of Round 1; still early in the fight, with significant opportunities remaining. A pull-back in stocks of as much as 10% would not be surprising or unwarranted and serve only to extend the current buying opportunity. The strength of corporate earnings in the second half will determine the direction of stock prices in coming quarters. Earnings are currently showing tepid signs of strengthening.
Easing of the credit crisis has restored some stability to the bond markets as evidenced by the rally in corporate bonds and several successful new issuances. Municipal bonds remain problematic as municipalities struggle with falling tax revenues.
On balance, I believe that the outlook for a positive end to the year is bright. There is a significant possibility that economic growth (GDP) will return, marking an end to the current recession. Should that occur, the unemployment rate will peak and then begin to decline, giving a further boost to investor sentiment and overall consumer confidence.
Timothy R. Meyer
President & Chief Investment Officer
The distinction between “not losing money” and “making money” cannot be overstated and is easily forgotten, even ignored, when fear runs rampant. The former involves risk aversion behavior while the latter requires risk seeking behavior. Thought of this way, it’s easy to see that these two approaches are opposites that require equally opposite investment strategies to achieve. The trick to reconciling these seemingly mutually exclusive states is as follows (in order):
1. Remain focused on capital appreciation, or making money; in good times and bad. Do not let market turmoil change your mindset lest you lose sight of why you invested in the first place (and your goal!). The portfolio strategy you designed to maximize total rate-of-return over your personal investment time horizon is not changed by short-term events (e.g., economic recession).
2. Distinguish between temporary capital losses & permanent capital losses and reconcile yourself to accepting temporary losses in exchange for higher long-term rates-of-return. This requires the temporary suspension of your average annual rate-of-return expectations during short-term market corrections and more prolonged bear markets. Your long-term average annual rate-of-return expectations remain unchanged.
3. Rebalance your portfolio’s asset allocation as aggressively as your frayed nerves will allow to recover from temporary capital losses and ultimately achieve higher long-term rates-of-return. I acknowledge that the positive impact of rebalancing, diversification, etc. is diminished when virtually every asset class tanks as occurred in 2008. Thankfully, global meltdowns like that one are rare and constitute an exception to the rule. Bottom-line, nothing is 100% fool-proof, 100% of the time.
Did Your Portfolio Participate in the Rally?
Too many investors are content to look at the dollar change in their total portfolio value at the end of a period and, if it’s positive, conclude that they’ve done well. This is too simplistic. Just because the market did well does not guarantee that your portfolio did too. It’s important to know if your portfolio benefited in proportion to the market’s gains. Good for you if it did. However, if it outperformed or underperformed, that could be a call to action.
Consider that emerging market stocks, real estate investment trusts, and financial stocks were decimated by the recession. Share prices collapsed as investors sold them in droves in favor of the perceived safety of U.S. Treasury bonds. Consequently, these assets are under-represented in many private portfolios. “Good riddance,” you might say. Yet emerging markets, REITs and financials led the second quarter rally with gains of +25%, +29% and +35%, respectively. In India alone, the benchmark Sensex Index gained +49% in just 12 weeks. As we’ve seen again & again, yesterday’s laggards often become today’s leaders.
Conversely, the safe haven many investors sought, U.S. Treasury bonds, declined -3% for the quarter, taking its losses for the first half of the year to -4.4%. This is the worst six-month performance in the history of Merrill Lynch’s Treasury Master Index, according to the Wall Street Journal. The benchmark 10-year Treasurys lost as much as -6% on the quarter. Riskier corporate bonds and high-yield “junk” bonds gained +23% for the quarter underscoring investors’ new appetite for risk.
Where Does the Rally Leave Us Now?
Some argue that the market has gotten ahead of itself and is due for a pull-back. Others believe the recent rally is a bear market trap and further declines lie ahead. Even Treasury Secretary Geithner conceded that the current recession isn’t over and a double-dip recession is possible. Looming inflation is an ongoing concern, as is the stability of the U.S. dollar. These are real concerns that cannot be discounted.
My view is that we are at the end of Round 1; still early in the fight, with significant opportunities remaining. A pull-back in stocks of as much as 10% would not be surprising or unwarranted and serve only to extend the current buying opportunity. The strength of corporate earnings in the second half will determine the direction of stock prices in coming quarters. Earnings are currently showing tepid signs of strengthening.
Easing of the credit crisis has restored some stability to the bond markets as evidenced by the rally in corporate bonds and several successful new issuances. Municipal bonds remain problematic as municipalities struggle with falling tax revenues.
On balance, I believe that the outlook for a positive end to the year is bright. There is a significant possibility that economic growth (GDP) will return, marking an end to the current recession. Should that occur, the unemployment rate will peak and then begin to decline, giving a further boost to investor sentiment and overall consumer confidence.
Timothy R. Meyer
President & Chief Investment Officer
Posted by Meyer Capital at
4:33 PM
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