US and developed foreign equity markets were both down marginally for the quarter.
However, this lackluster result masks the high level of volatility during the quarter as markets surged in April, pulled back sharply in May thru early June, and then surged again towards the end of June.
Chart I – S&P 500 Volatility During Q2-2011
Market volatility appeared driven by a “Risk-On / Risk-Off” mentality, with investors reacting enthusiastically to positive economic announcements, and pessimistically to releases of negative economic data.
Furthermore, with light summer volume, it didn’t take much to move the market dramatically in one direction or the other.
Chart II – S&P 500 Trading Volume – Low During Q2/2011
Outside of US equities, emerging markets continued to struggle with a modest 3% loss for the quarter, due to continued tightening of fiscal policies. However, towards the end of the quarter, emerging markets began to rally as commodity prices pulled back and inflationary pressures began to recede.
Gainers for the quarter included US treasuries on a risk avoidance play (e.g. the Greek and Euro debt crisis resulted in money moving to what was deemed the “safest” global asset in US Treasuries), as well as real estate which offered a steady stream of dividend payouts due to strong rental incomes.
Running to Stand Still
Portfolio Review (Q1/2011)
Similar to Q1, we entered Q2 positioning client portfolios in line with the thesis that equity markets would continue to rally, albeit with corrections along the way.
Our equity models indicated that emerging markets would regain leadership, after temporarily underperforming during the previous two quarters.
In fixed income, we remained over-weight in high-yield bonds and commodity-linked foreign bonds, and continued to short US treasuries on the expectation of an eventual rising in interest rates.
We also continued operating our relatively new VTM (Volatility Timing Model) to hedge against potential declines and to add beta during up trends.
Q: What worked?
Amongst our various asset classes and investment strategies, the following contributed positively:
- High-yield and convertible bonds delivered consistent returns
- Real estate delivered modest dividends while holding their price values.
- Our Volatility Timing Model (VTM) contributed approximately 1.1% of absolute performance relative to markets.
Q: What didn’t work?
The following positions underperformed or contributed negatively to portfolios:
- Our long-term overweight of Emerging Markets equities once again delivered a negative return as markets cooled off (this has been a long-term winner and we expect it to continue doing so when the uptrend resumes).
- Our short US Treasuries positions slightly underperformed due to renewed risk aversion (we expect good upside here unless another major calamity strikes hard).
- Commodities, commodity-linked countries, and commodity-linked companies declined sharply on US dollar strength and economic concerns
Net Results
Client portfolios mirrored the slightly negative return of markets during Q2, after having reached yearly highs in Q1/2011.
While certain core long-term holdings underperformed, we made up for this temporary decline with other outperforming asset classes and our supplemental VTM short-term trading strategy.
Recoveries are always choppy, and tend to have mixed signals mid-way through the cycle. This cycle appears to be exhibiting similar characteristics.
However, investing is a long-term endeavor that often requires patience and perseverance. Q2 was one of those quarters where a lot of work was done, and yet there was little to show, effectively “running to stand still.”
As always, we applaud our clients for continuing with their savings and investment plans while we work hard to plan, grow, and protect their assets.
The Choppy Hand-Off Continues
Looking Ahead
Our models indicate that equity markets will remain range-bound for the near future, within an 8-10% volatility band.
Markets will continue to weigh the positives of strong corporate profits and strengthening of consumer spending versus a myriad of government debt issues (e.g. stimulus removal, US debt ceiling issues, European debt crisis, etc.).
Furthermore, the economic recovery will continue to attempt a handoff from a highly indebted government to the healthier private sector, but there will certainly be hiccups along the way.
Economically speaking, the net effect should be a slow recovery in the near-term, particularly for lower-skilled workers in America (posting 15% unemployment rates versus 5% rates for college educated and trade skill workers).
Additionally, investment sentiment will remain poor based on the mediocre economic rebound and lingering fears / pain from the ’08 downturn.
However, we are bullish over the long-term as the massive rise of the global middle-class is setting the stage for incredible growth in equity markets for years to come.
There will surely be both minor and major downturns along the way, but for those companies and investors who tap into this growth, there is an immense opportunity.
In our asset allocation models, we are maintaining an overweight position in Emerging Markets equities, especially in countries where inflation is docile (e.g. Singapore, Taiwan, S. Korea).
In the US, we have largely moved to defensive sectors such as large caps and health-care ETFs.
For fixed income, we remain committed to our short US Treasuries position at such low rates, and have added some inflation-protected securities.
In commodities, we added to our energy exposure after the recent dip, having reduced exposure at higher levels in Q1.
We also continue to believe the US dollar will fall, and are holding the Canadian Dollar, Euro, and Brazilian Real as a hedge against this potential decline.