The “green light” flashed by the Fed’s bond purchase program, announced by Fed Chairman Ben Bernanke last August and discussed in our January Harmonic Notes e-newsletter, continued to blaze in its full glory. Stocks continued to rise until mid-February then faded by about -6% through mid-March. Treasury bond yields reached their most recent peak a few days earlier, then began to decline as more investors began to share Harmonic’s concern about asset valuations in the face of geopolitical concerns.

US Trade Weighted $ (white solid), Barclays Aggregate Bond Index (yellow dashed), Case-Shiller monthly 20-city home price index (blue dotted), S&P500 (red dotted), S&P Goldman Sachs Commodity Index (green dashed) –daily 8/24/10 to 3/18/10, normalized as of 8/24/10 {GRAPH: BLOOMBERG}

Divining the expected performance of stocks and other asset classes post-QE2 has become a recent preoccupation for many investors, made more complex by the recent natural and man-made disasters in Japan.

STOCKS

US stock indices moved about 5% higher after we distributed our mid-January newsletter, with the “risk on” trade firmly intact until mid-February.  Small company stocks continued to outperform those of large firms and cyclical sectors outperformed more defensive ones. Foreign stocks lagged slightly. However, the concerns that we voiced in our last missive seem to have permeated investors’ psyches, and stocks began to falter in mid-February touched off by a sharp rise in the price of oil caused by unrest in the Middle East.  Stock indices reached their most recent low on March 16 on a cascade of poor economic news and fears about a nuclear catastrophe in Japan, only to rebound sharply the following day when the crisis seemed to be in hand.

Relative performance of largecap stocks (Russell 1000 – white), smallcap stocks (Russell 2000 – orange) and developed market foreign stocks (MSCI EAFE – yellow); 1/25/11 to 3/17/11, indexed to 1/25/11 value {GRAPH: BLOOMBERG}

S&P500 sector performance relative to the S&P500 index, 1/27/11 – 2/17/11. Note the outperformance of the more cyclical sectors (consumer discretionary, technology, industrials, materials, energy) {CHART: StockCharts.com}

S&P500 sector performance relative to the S&P500 index, 2/17/11 – 3/17/11. Note the reversal of the earlier period’s performance and strength of the defensive sectors (consumer staples, healthcare, utilities) {CHART: StockCharts.com}

As we noted in the last newsletter, though, hopes are high for stocks in 2011. The consensus among stock market forecasters is that the market will end 2011 higher. Most argue that higher sales volumes and wider margins will lift earnings and that P/E multiples will expand as the economy continues to strengthen.

{CHART: Bespoke Investment Group, as of 3/9/11}

Also, several market omens bode well for stock performance this year. First, this is the third of the four Presidential election cycle.

Second, market participants also note that January’s +2.3% return bodes well for the remainder of this year. According to the book Seasonal Anomalies, “for the 71 years spanning 1940-2010, when the S&P 500 Index is up (down) during January, it is up (down) for the rest of the year 86.4% (48.1%) of the time. For 1994-2010, when January is up, the rest of the year is up 80% of the time.”

More fundamentally, expectations are for strong corporate earnings for first and second quarters of 2011. Indeed, Standard & Poor’s suggests that 1H11 earnings will hit new record highs.

Even considering the hopefulness and bullishness, we remain skeptical. We’re wondering if another old market axiom will hold true this year: “Sell in May and go away”.

{CHART: CXO ADVISORY GROUP}

Even in the third year of the Presidential election cycle there’s a distinct performance tilt in favor of the first half of the year.

Monthly S&P500 total return in third year of Presidential election cycles since 1975; note average at top of table

That seasonal weakness in the markets may be exacerbated by the conclusion of Fed’s QE2 bond purchase program in June.

S&P500 (orange, left scale) and Federal Reserve total assets (white, right scale), 3/2/09 – 3/17/11

As noted above corporate earnings have been exceptionally strong, but sharply higher commodity prices have the potential to create margin pressure. Should increased demand appear as the economy strengthens, growing payrolls present a second source of increased margin pressure. In short, we think there’s a low probability of margin expansion driving further earnings growth.

Corporate profits % of GDP (white), S&P500 (red), log scale quarterly Dec 1947 – Dec 2010 {GRAPH: Bloomberg}

Also, stocks appear expensive, or nearly so, on valuation metrics we watch. The S&P500 market-cap to GDP ratio, after touching 120% in late February, remains near that critical threshold.

S&P500 market cap to GDP ratio, 5/14/04 – 8/18/11 {GRAPH: Bloomberg}

The inflation-adjusted trailing 10-year average PE ratio (Cyclically-adjusted PE, or CAPE) is more than 1 standard deviation over its long-term average.

http://www.econ.yale.edu/~shiller/data.htm; Harmonic Investment Advisors calculations

It’s worth noting that higher interest rates suggest a lower fair value for stocks.

A longer term headwind is that P/E multiples are in a multi-year contractionary phase, so even if corporate earnings remain solid the index level may decline.

S&P500 P/E ratio, weekly, 1/2/70 – 3/18/11 {GRAPH: BLOOMBERG}

All in all, we’ve enjoyed the run-up in stock prices as much as anyone. But…

• the market sentiment’s clearly become more nervous,
• we’re nearing the end of the most favorable calendar period,
• valuations are, if not rich, nearly so, AND
• economic and market behavior post-QE2 is anything but clear.

We’re not expecting a crash, but things may get a little dicey for stocks later this year.

BONDS

Global bond yields tracked the performance of stocks over the past two months, with yields rising through mid-February and then turning lower as market participants bought bonds to reduce their risk profile.

US (white), EU (orange), UK (yellow) and Japan (blue) 10-year government bond yields, 1 year (daily) ending 3/18/11 {GRAPH: Bloomberg}

Yield spreads between Treasuries and the highest risk bonds – aka “junk” – behaved similar to stocks, contracting until mid-February then widening over the past month. Yield spreads on higher quality bonds have remained fairly stable.  Spreads indicate the additional yield investors require to accept the risk of holding a non-Treasury bond, so contraction suggests less risk aversion.

“B”-rated (top), “BBB”-rated (middle) and “A”-rated (bottom) 10-year corporate bond yields, 1/25/11 – 3/18/11 (daily) {GRAPH: BLOOMBERG}

As one would expect given the inflation-creating potential of an additional $900 billion sloshing around in the economy, inflation expectations have risen since Bernanke’s speech.  Those expectations are easiest measured by the spread between inflation-protected bonds and nominal bonds (For a discussion of TIPS yields please see the Economic Insight section of this newsletter). While down slightly from their recent peak, inflation expectations over the next 10 years remain at a historically average 2.40% (240 basis points). Expectations for inflation over the next 2 years, however, have risen by about 1.0% over the past 3 months.

Yield difference between 2 Year (dotted, bottom) and 10 year (dashed, top) maturity TIPS and nominal Treasury bonds, daily 3 months ending 3/18/11 {GRAPH: BLOOMBERG}

After weathering a pounding fueled by supply concerns and default fears, the municipal bond market rebounded somewhat as investors speculated, as we proposed in our January newsletter, that the selloff had been overdone.

TOP: Generic municipal bond yield curve 1/25/11 (dashed) & 3/18/11 (solid)

BOTTOM: yield change in basis points

{GRAPH: BLOOMBERG}

Our expectation is for somewhat higher bond yields in the coming months, given rising inflation expectations. We also share the concern, noted in Bill Gross’s recent Investment Outlook piece for PIMCO, that when the Fed stops purchasing Treasury and mortgage-backed securities in June that a significant adjustment may take place.

{GRAPH: PIMCO}

The rise in yields will likely be interrupted by occasional flights-to-quality, such as the recent cataclysm in Japan and downgrades of “peripheral” European countries like Portugal and Ireland.

Harmonic’s bond clients are positioned conservatively: We’re underweighted in that asset class as a whole and we’ve preferred bonds that have short maturities with attractive credit profiles.

COMMODITIES

Commodity prices have been one of the star performers since the Federal Open Market Committee announced QE2.  Not all commodities have reacted alike however.

Anyone who’s purchased gasoline in the last few months is aware of the latest spike in energy prices.  Oil has dropped back to about $100 after hitting its most recent high above $105, rocketing 25% in less than one month. As noted in this month’s Economic Insight food commodity prices have risen sharply as well.

Given its historical role as a hedge against uncertainty, gold is perhaps the ultimate asset for risk adverse investors.  The spot price of gold climbed along with other commodities through November; however, since then it has traded sideways, somewhat contradicting the inflation concerns suggested by inflation-protected bonds.

TOP: Spot gold (orange), Brent crude oil (green) and Bloomberg Food & Fiber commodity index (purple)

BOTTOM: S&P Goldman Sachs commodities Index

Daily 8/24/10 to 3/18/11, normalized to 8/24/11 {CHART: BLOOMBERG}

Commodity prices are subject to demand destruction; for instance, if the price of gasoline gets too high, people will begin carpooling or riding their bikes to work. Analysts differ on the exact figure but seem to agree that that demand destruction may kick in if oil rises much beyond current levels. We notice, though, there’s been much less complaining about high gasoline prices than when they last spiked in 2008, evidence to us that Americans are behaving normally – after an adjustment period they adapt. This type of behavior drives economists crazy because it’s “irrational” but we think it supports a long-term bullish view on commodity prices. There’s no more oil, gold, or natural gas being made, so to speak, but barring a multi-year global recession demand isn’t likely to abate for long.

REAL ESTATE

Harmonic gives clients exposure to the commercial real estate market via real estate investment trusts. One advantage of using real estate in an investment portfolio is that the real estate cycle is somewhat different than the stock and bond cycles.  However, since REITs are a type of common stock they have a moderate correlation with the stock market. That, and the fact that REITs usually offer a relatively high yield, has pulled them higher in recent months. Since our last newsletter REITs performed in line with the S&P500 until risk aversion set in, and then benefitted from their higher yield and lower volatility compared to the broader stock market.

Dow Jones US REIT Index (white solid) & S&P500 (orange dotted), daily 1/25/11 to 3/18/11, indexed to 1/25/11 {GRAPH: BLOOMBERG}

POSITIONING

With only a temporary tactically change, we’re positioned as we were in January. At that time we were overweight equities in order to take advantage of the rally, having shifted client assets towards stocks and commodities while lightening up on bonds when it became clear the Fed intended to put its money where Bernanke’s mouth was. As our concern rose about a near-term correction, in late January we hedged a portion of clients’ stock positions, a tactical trade which proved prescient as the Middle East erupted. We expect to remove the hedge shortly.

We continue to focus on high quality stocks rather than more speculative ones. Also, as noted above we’ve shortened the maturity of our bond portfolios, preferring to capture yield by taking more credit risk, which we have the skills and experience to evaluate, instead of duration risk.

The rally that began September 1^st 2010 continued its run higher more-or-less uninterrupted through year-end.  The Russell 3000, a broad US stock market index, rose +11.6% during 4Q10 and has continued to move higher through the first three weeks of January. As we noted in our previous newsletter (and in the Economic Insight segment of this one), stocks have been the beneficiary of the Fed’s initiation of bond purchases, also known as QE2. Oddly though, Treasury bond prices have fallen during this same period, contradicting what one would expect to be the normal reaction when there’s a large and continuous buyer in the market. Other types of bonds continued to perform well and commodity prices joined stocks on their rise.

STOCKS

While the “quality” of the market action is questionable given our belief that the latest round of Fed bond purchases won’t much help the economy, stock investors jumped on the proverbial bandwagon and the market continued to roar higher. The uncertainty represented by the election is out of the way, giving stocks clearer sailing. That the fourth quarter of the year typically has the best performance was also not lost on stock investors. Foreign stocks also benefitted, although the aimless performance of the US$ hasn’t been as great a tailwind for domestic investors as in previous periods.

Relative performance of largecap stocks (Russell 1000 – white), smallcap stocks (Russell 2000 – green) and developed market foreign stocks (MSCI EAFE – red); 11/15/10 to 1/25/11, indexed to 11/15/10 value {GRAPH: BLOOMBERG}

The stock market has had several things going for it during recent weeks: First, the third year of the four year Presidential election cycle has traditionally been the strongest for stock market performance. The usual explanation for this phenomenon is that the sitting Administration, often aided by the Federal Reserve, pulls out the stops to try to curry voters’ favor for the upcoming election. Some anticipation of this phenomenon probably accounts for the surge through year-end and so far in 2011.

Second, the fourth and first quarters historically comprise the strongest half of the year.

{CHART: CXO ADVISORY GROUP}

Third, corporate earnings have been quite strong for several quarters now, beating consensus estimates and giving bulls more fundamental support for their case.

Finally, the aforementioned QE2 has for all intents and purposes flashed a green light to investors in risk assets like stocks and commodities. As we mention in this month’s Economic Insight, QE2 probably won’t do much for unemployment or house prices but it has done wonders for stocks and commodities.

US Trade Weighted $ (white solid), Lehman Brothers Aggregate Bond Index (yellow dashed), Case-Shiller monthly 20-city home price index (blue dotted), S&P500 (red dotted), S&P Goldman Sachs Commodity Index (green dashed) –daily 8/24/10 to 1/25/10, normalized as of 8/24/10 {GRAPH: BLOOMBERG}

The consensus among market watchers is that stocks are overextended and due to pause in the near-term. That said, we’re learned the hard way that, according to John Maynard Keynes, “The market can remain irrational longer than you can stay solvent,” so we’re remaining vigilant.

We noted in the last newsletter that we were looking for financial stocks to confirm any rally and have been pleased to note that the financial sector has been one of the leading sectors of late.

S&P500 Sector Performance relative to the S&P500 {CHART: STOCKCHARTS.COM}

The consensus among stock market forecasters is that the market will end 2011 higher. Most argue that higher sales volumes and wider margins will left earnings and that P/E multiples will expand as the economy regains its composure. We tend to disagree; earnings are currently strong but may fade in 2H11, margins are near all-time highs and P/E multiples are, we believe, on a multi-year contractionary phase.

S&P500 P/E ratio, weekly, 1/2/70 – 1/27/11 {GRAPH: BLOOMBERG}

US stock mutual funds have only recently begun to see inflows, coming largely at the expense of bond funds. Those flows are noteworthy because they reverse a multi-year trend of individual investors moving money away from stocks. Historically, individual investors were a great contrary indicator for smart money, as individuals tend to be last to jump on the bandwagon. We wonder if they collectively bought bonds at the lowest interest rates in a generation only to move their funds into stocks as equities turn lower.

BONDS

The key lesson from Macroeconomics 101 is that increasing the demand for something will, leaving all other things unchanged, raise the price.  Therefore we and most market participants expected the Fed’s ongoing purchases under the banner of QE2 to depress US Treasury yields. Treasury bond yields have risen, however, since our last note. Confusing the issuer further is that the yields of UK, German, Eurozone, Japanese and other countries’ bonds have risen alongside US Treasuries.  We’ve read research suggesting that this head-scratcher is due to the above-mentioned shift of mutual fund investors from bonds to stocks or that it could be large investors like sovereign wealth funds decreasing global bond holdings in anticipation of potential inflation and concerns about sovereign debt risk.  Regardless of the reason, we’re glad we sidestepped some of the punishment by tactically lightening clients’ bond holdings.

US Treasury (orange), UK Gilt (white), German Bund (red) and Japanese JGB (yellow) 10 yr bond yields, 1 year(daily) ending 1/27/11 {GRAPH: BLOOMBERG}

Yield spreads between Treasuries and the highest risk bonds – aka “junk” – have continued to contract while spreads on higher quality bonds have remained fairly stable.  Spreads indicate the additional yield investors require to accept the risk of holding a non-Treasury bond, so contraction suggests less risk aversion.  It remains to be seen whether risk aversion or risk seeking will win the race.

“B”-rated (light blue), “BBB”-rated (yellow) and “A”-rated (dark blue) 10-year corporate bond yields, 3-months ending 1/27/11 (daily) {GRAPH: BLOOMBERG}

As one would expect given the inflation-creating potential of an additional $900 billion sloshing around in the economy, inflation expectations have risen since Bernanke’s speech.  Those expectations are easiest measured by the spread between inflation-protected bonds and nominal bonds. The bond market seems to think inflation is more likely to come sooner than later:  Since their late August low spreads on bonds that mature in 2 years and 10 years have risen about 1.00% and 0.72% respectively.

Yield difference between 2 Year (orange) and 10 year (yellow) maturity TIPS and nominal Treasury bonds, daily 8/24/10 to 1/28/11 {GRAPH: BLOOMBERG}

The market for municipal bonds, a usually staid corner of interest mostly to wealthy individuals, has seen more than its usual share of activity lately. The selloff in the muni market was first linked, we think, to that in Treasuries, discussed above. However, municipal bonds were further pummeled as commentators speculated on the number and magnitude of potential municipal defaults.

TOP: Generic municipal bond yield curve 10/28/10 (orange) & 1/28/11 (green)

BOTTOM: yield change in basis points

{GRAPH: BLOOMBERG}

It’s clear that state and local governments are under tremendous pressure as tax and other revenue sources decline while, in some areas at least, the demand for public services increases. We think that the selloff is in part based on the potential for additional supply and an overreaction to rather alarmist media reports.

The bonds used in our clients’ portfolios have been carefully chosen based on their credit quality, geography, repayment source and other factors.  Obviously we’ll continue to monitor developments in state and local government finances and will make adjustments to client portfolios if necessary.

COMMODITIES

As mentioned at the beginning of this commentary commodity prices have been one of the star performers since the Federal Open Market Committee announced QE2.  Not all commodities have reacted alike however.

Anyone who’s purchased gasoline in the last few months is aware of the latest spike in energy prices.  Oil has dropped back to the high $80s after hitting its most recent high above $91. As noted in this month’s Economic Insight food commodity prices have risen sharply as well.

Given its historical role as a hedge against uncertainty, gold is perhaps the ultimate asset for risk adverse investors.  The spot price of gold climbed along with other commodities through November; however, since then it has traded sideways, somewhat contradicting the inflation concerns suggested by inflation-protected bonds.

Spot gold (white solid), light sweet crude oil (orange dotted) and Bloomberg Food & Fiber commodity index (purple solid), daily 8/24/10 to 1/28/11

{CHART: BLOOMBERG}

REAL ESTATE

Harmonic gives clients exposure to the commercial real estate market via real estate investment trusts. One advantage of using real estate in an investment portfolio is that the real estate cycle is somewhat different than the stock and bond cycles.  However, since REITs are a type of common stock they have a moderate correlation with the stock market. That, and the fact that REITs usually offer a relatively high yield, has pulled them higher in recent months.

Dow Jones US REIT Index (white solid) & S&P500 (orange dotted), daily 8/24/10 to 1/28/11, indexed to 8/24/10 {GRAPH: BLOOMBERG}

POSITIONING

We’re positioned to take advantage of the rally, having shifted client assets towards stocks and commodities while lightening up on bonds when it became clear the Fed intended to put its money where Bernanke’s mouth was. However, given the “low quality” of the rally we’re focusing on high quality stocks rather than more speculative ones. Also, we took some profits in longer-term bond holdings that benefited from the QE2-inspired rally and increased clients’ inflation hedge by adding to Treasury Inflation Protected bond positions.

As noted earlier we continue to think it’s likely that the US stock market “trades sideways” with higher than normal volatility for the next several years, suggesting that investors should become more tactical in their approach rather than pursuing a buy-and-hold strategy.