1st Quarter 2010 Review

From the Desk of Ron Rowland

Investing is all about taking risk. Most people have become keenly aware of this fact in the last two years, but it’s still worth a little discussion. The current situation gives us a unique opportunity. Let me explain.

You can define investment "risk" in many different ways. All of them have to do with the chance of losing money or missing opportunities. Risk is directly related - inversely - to reward. If you want more rewards, you have to take more risks. If you aren’t willing to take risks, you should expect smaller rewards.

For instance, if you buy a three-month U.S. Treasury Bill, your risk is extremely low. You will get your money back unless the government defaults in the next three months. You won't get much a return on your investment, but you knew that going in.

Conversely, suppose you buy stock in a small biotechnology company that is currently testing a drug that might cure cancer. If the drug works your reward will be great. If it doesn't work, you will probably take a huge loss.

The key to investment success is avoiding these two extremes. If all you ever do is buy T-Bills, you will lose ground to inflation and ultimately not meet your long-term goals. If you put all your money in a risky stock and it goes south, you'll have to start over again.

The problem is knowing where to place yourself on the spectrum. As humans, we are all subject to emotions and faulty thinking. Many people become overconfident in good times and too pessimistic in bad times. Your risk tolerance was probably different in 2007 than it was in 2002. This brings us to the opportunity I mentioned above.

Given that the fear of 2008-2009 has subsided but markets are still far away from the giddiness of new highs, now may be a good time to find the right balance. You can assess your risk tolerance with minimal outside interference. Think about it carefully, and then stick with whatever strategy you develop. We’ll be glad to help you work through these issues.

The Quarter in Review

Last year, the first quarter was marked by fear that in retrospect seems excessive. The first quarter of 2010 was the opposite: an optimism that may prove to have been unfounded. Indeed, any review of the numbers reveals investors positively embraced risk the last three months. Was it wise? We shall see.

The broad indexes had historically above-average results. The Dow Jones Industrial Average was up +4.1%, the S&P 500 with dividends gained +5.4%, and the Nasdaq Composite rose +5.7%. The Russell 2000 Small-Cap Index – a good proxy for investor risk appetite – jumped +8.5%. Micro-Cap indexes also performed well. While blue chips did well, our momentum tracking showed a bias toward the smaller end of the capitalization scale for most of the quarter. Buyers were clearly looking to take on more risk.

A deeper look at performance by industry is enlightening. Here are the first quarter results for the Select Sector SPDR ETF family, which breaks the S&P 500 down into nine sectors

Three sectors posted double-digit gains: Industrials, Financials and Consumer Discretionary. This combination is reflective of both big profits by banks and expectations of an economic rebound. The Industrials group, as defined by S&P, is dominated by General Electric (GE) which has a very large financial arm. Consumer Discretionary stocks rose on signs that consumers might start spending a little more freely.

As always, quarterly numbers mask what happened within the period. The new year opened with a rally that faded in mid-January. Plenty of investors were frightened away before a bottom formed in February. From there, the uptrend resumed for the rest of the quarter.

The domestic economy grew in the quarter, as it did in the last quarter of 2009, boosted by huge Treasury and Federal Reserve stimulus programs. Interest rates stabilized within a trading range but still at a historically low level. Perhaps the quarter’s most remarkable trend was a recovery in the U.S. Dollar. Weakness in the Euro had a lot to do with this as the Europeans wrestled with huge government debt in Greece and a handful of other previously-prosperous nations. China remained as enigmatic as ever, with the economy still booming and Westerners wondering how it could be possible.

Will 2010 be like the year before? The near-meltdown in the first quarter of 2009 was certainly not indicative of the strong rally that followed. A remarkable reversal turned the calendar year into a success for those who bought – and held on – for the entire period. The year 2010 could bring a turnaround of similar magnitude but different direction.