Kanaly Blog

2008 Year-to-date Investment Performance

The S&P flirted with 1,400 for the first time since early January, closing at 1,385 with its best monthly return since 2003. The drivers for this price recovery have been the slew of positive first quarter earnings from the likes of Google, Boeing and American Express. According to Bloomberg, 63% of the companies in the S&P 500 that have reported earnings so far have positively surprised. Accordingly, the Dow Jones Industrial Average rose 4.7% to close at just under 13,000, while the tech-heavy NASDAQ jumped nearly 6% to close at 2,413.

International developed markets rebounded strongly, while emerging markets soared even more, as last month’s brutal sell off appears, at least for now, to have ended. The MSCI EAFE index gained 5.6%, and the MSCI Emerging Markets added 8.1% in April. Small caps lagged their larger counterparts, as the S&P Citigroup EMI ex-US index rose 2.3% during the month. The proximate cause for the strong rally is difficult to pinpoint. Maybe there was too much pessimism on the part of media, and investors decided to put some of their cash to work? Perhaps markets breathed a sigh of relief, as another Bear Stearns situation did not turn up.

Treasuries retreated 1.7% in April, the first monthly loss since June, as investors regained their appetite for riskier assets. Flows out of money market funds into high yield fixed income funds increased. Investment grade corporate credit issuance shattered previous monthly records, with more than $101 billion coming to market as many financial institutions took advantage of improved market conditions.

Performance for each of Kanaly’s equity models generally kept pace with the market in April, despite having a defensive bias. Most sectors contributed positively, led by the energy, financials, and consumer discretionary sectors. Some of our more defensive holdings in the consumer staples and health care sectors lagged the market. Year-to-date, the Core, Growth & Income, and Diversified models are significantly outperforming the S&P 500 index.

So should April’s rally in equity markets be taken as an “all is clear” sign to investors? As strategic long-term investors, we simply do not know. Certainly more write downs related to credit at large European banks and a tightening of global food situation are distinct possibilities. Either of these two situations could add to political and market discord in various regions across the world. Additionally, we still believe that volatility and dispersion of returns across countries and sectors will continue. Having been long-term students of the markets, we also realize that when investor sentiment turns too strongly in either direction, sharp and often violent market movements in the opposite direction can occur. Investors should remain well diversified and expect continued volatility.

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4/18/08 Market Update

U.S. stocks have rallied nearly 10% over the last month based on a handful of positive developments. First, the Federal Reserve-orchestrated buyout of Bear Stearns greatly reduced the probability of a financial system collapse. The President and Congress seemed committed to prevent a deep recession in this election year. In addition, many bank CEOs have expressed confidence that the worst of the credit market turmoil has passed. As a result, many investors expect that any recession will be short and shallow, with stronger economic growth just around the corner. Finally, first quarter corporate earnings, excluding GE’s surprising disappointment, have been better than expected from large companies such as Intel, IBM, Google, Caterpillar, JP Morgan, Honeywell, and Citigroup.

However, this may just be yet another bear market rally, and it is prudent to take a little off the table, based on the following:

• The credit markets continue to show signs of significant stress. This week's big news was that banks may be under-reporting their true borrowing costs in the LIBOR markets, resulting in a substantial rise in borrowing costs over the past few days. If banks continue to hoard cash, then the borrowers most in need of credit have no access. This leads to slower economic growth, and a long de-leveraging process.
• Data released this week indicates the housing market continues to deteriorate. Housing starts have plunged to the lowest level since 1991, and declined by double the rate expected by economists in March. Housing weakness triggered the credit market turmoil, so it is difficult to see the light at the end of the tunnel without some signs of stability in the housing market.
• Commodity price inflation shows no signs of slowing as crude oil touched a record $117 a barrel today. There is a global shortage of key commodities, subjecting consumers and corporations to higher cost burdens at a difficult time.
• Major stock indices are now trading at the top of a range that has persisted for much of 2008.

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2008 Year-to-date Investment Performance

   Our 2008 market strategy called for a difficult start to the year due to credit market troubles and fears of recession. The month of March was filled with headlines consistent with this theme: the emergency bail-out of Bear Stearns by JPMorgan and the Federal Reserve; the Fed’s opening of the discount window to non-banks; lower than expected consumer confidence data; falling housing prices and an 8% drop in auto sales from a year ago. These were just some of the enflamed topics which burned even brighter with the help of expensive oil. However, markets showed signs of attempting to find a bottom as the S&P 500, Dow Industrial Average and the NASDAQ turned in the best performance since October of last year.

   International developed markets fell slightly, while emerging markets sold off sharply, especially in Asia, during yet another volatile month. For March, the MSCI EAFE index lost 1.0%, and the MSCI Emerging Markets dropped 5.3%. Volatility continued as expected - and for good reason. What is likely the largest credit bubble in the history of the world continues to unwind, and despite the proclamations of many a pundit that the situation is “contained,” one could easily take the position that many more write-offs and credit problems are lurking in various corners of the world.

   Kanaly’s equity models have delivered strong outperformance in this difficult market environment. Our three individual stock portfolios (Core, Growth & Income, and Diversified) are outperforming the S&P 500 Index by well over 200 basis points through the end of March. As I mentioned in my last post, our relatively stronger performance is due to a more defensive position for our portfolios, along with a reduction in equity exposure.

   The Fed’s actions in the case of Bear Stearns, as well as recent successful raisings of capital by investment banks, have restored some confidence in financial markets. However, the ultimate economic impact remains uncertain as credit market conditions remain tight, unemployment is rising, and commodity prices are high. As a result, we maintain a cautious, relatively defensive approach and remain underweight in financials and consumer-related stocks.

   We expect the market to find strong support near the lows reached intraday on January 23 and March 16. In the days and weeks ahead, we will be watching for further evidence of market bottoming action. Should those signs emerge, we will turn more bullish on the market’s prospects.

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2008 Year-to-date Investment Performance

   Equity markets have struggled to a poor start to 2008 due to continued concerns in the credit markets and fears of a recession.  Virtually all asset classes aside from commodities and Treasury securities have posted declines this year.  However, Kanaly’s equity models have delivered strong outperformance in this difficult market environment.  Our three individual stock portfolios (Core, Growth & Income, and Diversified) are outperforming the S&P 500 Index by over 200 basis points through the end of February.  This margin has since expanded over the first two weeks of March.

   Our relatively stronger performance is due to two primary factors:

• First, beginning near the end of last year, we moved the portfolios to a more defensive position, selling more volatile and economically sensitive holdings in industries such as banking, retailing and technology.  We also eliminated our position in a China exchange-traded fund. The proceeds were invested in stocks with defensive growth characteristics in the energy, consumer staples, utilities and health care sectors. 
• Second, we reduced our equity exposure by 5% across all models in early February, a move that has cushioned the portfolios during the downturn over the last six weeks.

   We expect the market to find strong support near the lows reached intraday on January 23.  In the days and weeks ahead, we will be watching for the classic signs of market bottoming action.  Should those signs emerge, we will turn more bullish on the market’s prospects.

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Market Update 3/11/08

   This morning the Federal Reserve announced plans to lend up to $200 billion to banks, and will accept both agency and private mortgage-backed securities. The markets are enthusiastically welcoming this news as it provides much-needed liquidity to credit markets that have been melting down in recent days. 

   This increases the odds that yesterday marked a successful retest of the January 23^rd low. We will see massive short-covering today, driving strong gains in the equity markets. However, before becoming more aggressive towards equities, we need to see if this action by the Fed is successful in restoring calm to the credit markets.

   This week, our Chairman Drew Kanaly was featured on CNBC "Squawk on the Street" and our Chief Investment Officer James Shelton was featured on CNBC "Worldwide Exchange" to discuss the latest news on the marketplace. Follow the links to hear what they had to say.

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Market Update 3/4/08

   After rallying for nearly three weeks, equity markets sold off sharply on Friday to end the month in the red.  Dismal economic news including higher inflation readings, continued declines in home prices, and worse than expected orders for durable goods indicate the U.S. economy is brushing with a recession.  In addition, crude oil neared its inflation-adjusted record of almost $104 per barrel as commodity prices surged, putting further pressure on consumers and businesses.

   In addition, the credit market dislocation spread to high quality assets last week.  The municipal bond market is experiencing substantial liquidity-driven turmoil, as prices have fallen for 14 consecutive days and February was the worst monthly performance for municipal bonds in 19 years.  The selling pressure was broad-based, from high quality AAA-rated bonds to high yield bonds.  However, unlike the subprime mortgage crisis, the selling in the municipal bond market has not been caused by problems with credit quality.  As a result, this market dislocation has created a major opportunity for investors to take advantage of historically high tax-exempt yields relative to Treasuries.

   The current market environment is unfortunately consistent with our forecast for the first half of 2008.  Uncertainty over the ultimate scale of the credit crisis and associated de-leveraging process, along with the slowdown in the economy, has created a volatile trading environment.  We continue to advise a cautious approach to riskier assets.  We believe the S&P 500 has strong support near the January intraday low of 1270, and expect resistance near 1400 until uncertainties begin to ease.

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Market Update 2/6/08

   The January employment report released Friday by the Labor Department indicates the U.S. economy is teetering on the edge of recession. Assuming this data does not get revised upward in the months ahead, the economy lost jobs in January (-17,000) for the first time since August 2003. Employment had been one of the few remaining areas of strength, so this deterioration underscores our cautious approach to the markets early in 2008.

   Curiously, stock prices continued to advance following Friday’s employment report. In fact, the S&P 500 posted its best weekly gain in almost five years, rallying nearly 10% from the January low in only eight days. We believe much of the rally was driven by short-covering, not a sign that the bull market has regained traction. As a result, we took the opportunity to reduce equity exposure across our models by 5% as we believe the market is at risk of eventually revisiting the January lows.

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Market Update 1/30/08

   Though this morning's economic data was mixed, growth is clearly weak. The advance report on fourth quarter Gross Domestic Product showed weak growth of 0.6%, half of the consensus estimate of 1.2%. But employment is hanging in there, as ADP reported 130,000 new jobs in January, reinforcing the lack of job layoffs indicated by recent data on claims for unemployment insurance.

   The big drivers for the weak GDP report were large declines in home construction and inventories, subtracting 1.2 and 1.3 percentage points from GDP, respectively. Consumer spending rose 2% and business investment rose 7.5%. This report boosts odds of a 50 basis point cut in Fed Funds today at 1:15 p.m.

   Bottom line is the housing fallout is spreading to the overall economy, but low inventories and low unemployment claims are encouraging. A cautious approach to equity markets remains warranted.

  This morning, our Chairman, Drew Kanaly, appeared on the CNBC's "Squawk on the Street." Click on the link to hear what he said about the Fed meeting and other top issues.

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Market Update 1/25/08

   Wednesday’s markets initially sold off and tested the low point we saw on Tuesday. However, Tuesday’s low held and the market rallied strongly.  We believe this marker a near term low, not the bottom from which a major bull market will start. The tax stimulus and Fed action is welcome, but may act more as a “band-aid”; however, it is calming investor’s fears. There’s a small rally going on right now for 5-10%, which is giving us the opportunity to make adjustments, raise some cash and wait and watch for a sign of a major bottom.

   This week, unemployment claims were down. Next week, we will be watching for the GDP, the Fed meeting and jobless claims. 

   On Monday, our Chairman, Drew Kanaly, appeared on the Fox Business News Channel and on Wednesday, he was featured on Bloomberg TV's "Final Word." Click on the links to hear what he had to say about the markets.

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Market Update 1/22/08

   Given the action in overseas markets today and futures trading on U.S. markets, it is likely that we will see a substantial decline when trading resumes tomorrow.  European markets declined 5%-7% today, and S&P 500 Futures closed about 4.5% below Friday’s 1325 close.  Below are current thoughts:

   Our 2008 market outlook called for first half weakness and elevated volatility as markets focused on recession fears, the housing and debt crisis, and a slowdown in corporate earnings.  We saw downside risk in the S&P 500 to 1250 – 1300, or down 10% - 15%.  The surprising point is we’ve nearly reached that target just three weeks into the new year.  Markets are on track for the worst start in history.

   What is driving the rapid declines in equity markets?  Market psychology has turned on a dime, expecting the worst.  There has been no economic news released in recent days suggesting the economy is materially weaker than what most thought coming into 2008.  In fact, the market has ignored seemingly positive news – such as President Bush’s proposed $150 billion stimulus package, and Fed Chairman Bernanke’s pledge to “take substantial additional action as needed to support growth”.

   While the markets increasingly price in an economic recession in the U.S., the data is mixed.  Some of the recent data suggest a high risk of recession, or even that one has already begun.  The unemployment rate has risen from 4.4% to 5%, including a rare 0.3% rise in December.  Measures of manufacturing activity point to a downturn, and retail sales were soft in December. 

   However, not all of the economic news has been weak.  We have watched closely the data on employment and incomes for signs of a recession.  Weekly claims for unemployment insurance have been low and remain well below recessionary levels.  Monthly payroll employment growth, though tepid, remains positive and is not consistent with the sharp declines seen in a recession.  Consumer spending has slowed but remains positive, and spending on business equipment was up in Nov/Dec.  The economic calendar is very light this week, but next week we’ll get the advance report on 4^th quarter GDP, January payroll employment, personal income, and the ISM manufacturing index.  These reports will be a good gauge of where the economy is heading.

   What are the implications for our investment strategy?  First, this market correction has been global in scope with precious few places to hide, so our moves in the fourth quarter to boost high quality, defensive holdings in the portfolio have helped only marginally.  However, in recent days we have seen more intense selling in riskier areas such as emerging markets.  Second, while we would prefer to raise additional cash, now is not the time to do so.  Overseas trading today smacked of panicked selling, a trap long-term investors should avoid.  Finally, this type of market environment typically creates excellent buying opportunities, so we will be watching for signs of bottoming action.

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