1st Quarter 2009 Review

From the Desk of Ron Rowland

Caution remains the theme as 2009 unfolds. As the year opened we had already assumed a defensive posture in most of our programs. This served us well as we were able to avoid large losses as the financial markets continued to fall in January and February. It also means that we were mostly on the sidelines for the stratospheric rise in stocks that began in early March. I have no regrets; in this market I would much rather be safe than sorry.

Bear markets are tricky even for the nimblest of short-term traders. Bear market rallies can be fast and furious, leaving investors to think they are being left behind. Make no mistake about it: we are in a bear market, one so deep that even the big gains seen in March could not overcome the long-term downtrends in major benchmarks. The tide is still going out, not in.

On the other hand, even bear markets sometimes bring opportunities. The key to success is to be prudent about the risks we take at such times. As long as the bear appears to be in control, we will likely maintain larger cash reserves than normal and will demand a higher standard of proof in evaluating portfolio candidates.

Our task is complicated by the highest level of volatility the market has seen in recent years. So far in 2009, we have seen twenty days on which the S&P 500 moved by 3% or more. That’s an average of more than once a week. This makes trading extremely difficult. Think about it: if you buy one day early and sell one day late, your return could easily be 6% worse than it would have otherwise been. This is another reason we are reluctant to chase rallies.

Given all this, you might be tempted to give up and hold your entire portfolio in cash. I think that would be a mistake – and not just because cash yields are so low right now. The fact is the bear market will end at a point that will be obvious only in hindsight. By staying committed but cautious, we are increasing the odds that you will participate in the recovery, whenever it comes.

The Quarter in Review

For many investors, the first three months of 2009 did not feel quite as bad as the last quarter of 2008. This may be because the surprise and shock had worn off; having grown accustomed to wild swings, government interventions and a rapidly deepening recession, people became comfortably numb and just watched events unfold.

The numbers tell the story. In the first quarter the S&P 500 lost -11.0%, bringing its 12-month return down to -38.1%. The most recent three-year, five-year and ten-year windows are all negative, and the 15-year annual average return for the index is only +5.9%. All these returns include dividends. With many companies now cutting their dividends to conserve cash, they probably understate just how bad the damage has been.

The quarter was not an uninterrupted downtrend, however. There was a slight bounce in late January. A more extended bear market rally began on March 6 and persisted into April. The last three weeks of the quarter substantially reduced the damage to most benchmarks but still could not restore long-term indicators to bullish territory. The bear remains in control.

We like to look at the SPDR Sector ETFs to get a sense for how the gains were distributed between industry groups. Here are the quarterly returns, in descending order from best to worst.

For the most part these returns represent a bounce from starkly oversold conditions. No one has much to brag about, but Technology at least managed a small gain. Utilities and Consumer Staples are traditionally thought of as defensive sectors that outperform in a recession, but for this period they did not do better than the S&P 500 as a whole. The Financials sector set all kinds of volatility records during the quarter and staged a furious rally in March, but it still could not lift itself out of last place. The Industrials were weighed down by big losses in the transportation sub-sector along with a heavy weighting in General Electric (GE), which is sort of a financial company in disguise.

There was a substantial difference between Growth and Value stocks last quarter. As noted above, the S&P 500 was off -11.0%. If we split the index into Growth stocks and Value stocks, we find that the Growth side was down -6.2% and Value lost -16.1%. Neither is good, obviously, but Growth was not quite as bad as Value.

The International picture has a similar discrepancy: emerging markets far outpaced the "modern" world. The MSCI EAFE Index, which covers most of the developed world other than the U.S., lost -14.6% in dollar terms for the quarter. The MSCI Emerging Markets Index was actually up +0.5% for the same period, thanks to huge gains in China, Latin America and elsewhere. Of course these also happen to be the markets which fell the hardest in 2008, so some of this gain was simply an oversold bounce. Whether it can be sustained or not remains to be seen. Count us as doubtful.