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April 2013 Investment Journal 


Markets in April continued the year to date trend of equity outperformance and bond and "hard asset" underperformance:
The pendulum has now swung back to "risk on" assets leading, with "risk-off", or safe haven assets, lagging for the last three years:
The real anomaly is how handily developed markets have outperformed emerging markets in equities over the last three years, despite GDP growth being higher for longer in the emerging markets (notice the trend-lines in the graph below):



  Source:  Gavyn Davies/ FTAlphaville.com
Many observers have commented on how the central banks of the developed countries are "pumping up" their stock markets by all of the money-printing going on. That is not the case in Brazil, India, China, Russia, etc. (the BRIC's). We think there is some truth to this, but there is also a noticeable rotation underway into dividend paying stocks, and out of low yielding cash and bonds. The much smaller sizes of the emerging markets coupled with currency risk have made the larger markets destinations of choice for now.
If we step back to get a longer term view ("decades" time frame) of stocks, we are in a Secular Bear Market which began in 2000 when the P/E ratio peaked at about 44. (Note: all P/E references are to the Shiller P/E values, sometimes called PE10 or CAPE, which are calculated so as to remove shorter-term fluctuations; see robertshiller.com for details):

The job of Secular Bear markets is to burn off outrageously high P/E ratios over one or two decades, until finally the P/E ratio arrives back at a single-digit level, from which another Secular Bull Market can emerge. If history is a guide, we are not yet near the end of this Secular Bear Market. 
The CAPE is slightly higher at 23.2 from the prior month's 22.8.  Even though P/E's are now half what they were at their crazy peak in 2000, they are nonetheless at the high end of the normal range and leave little if any room for expansion:
This means that the stock market is unlikely to make gains greater than corporate profit growth percentage, if that. In fact, since 1881, the average annual returns for all twenty year periods that began with a P/E at this level have ranged from -2%/year to +7%/year with an average of just 3%/year.
This further means that above-average returns will be much more likely to come from the active management of portfolios than from passive buy-and-hold. Although a mania could come along and cause P/E's to shoot upward from current levels (such as happened in the late 1920's and the late 1990's), in the absence of such a mania, buy-and-hold investors will likely have a long wait until the arrival of the next Secular Bull Market.
US bonds in April resumed their rally, with the Ten Year Treasury moving from 1.87% to 1.70%. Bonds remain the "contrary indicator", and are the best signal of deflationary pressures building; the lower yields go, the more investors fear deflation. For now, investors have to own longer maturities to generate yield. The good news is, price trends are still positive, especially for lower quality paper. And, in the event of any stock market correction, longer duration, higher quality bonds will be a prime beneficiary.
Gold suffered a severe correction on April, falling from $1,600 an ounce to $1,352 in the first two weeks of the month. Most theories revolved around big banks and hedge funds repositioning due to a stronger dollar and weaker yen. There was also a lot of talk about investors selling their ETF's in to purchase actual bullion. Whatever the case, all precious metals experienced significant technical damage in April, and will take some time to recover.
From a macro standpoint, not much changed. Economies everywhere are growth challenged, and statistics paint a mixed picture, but are mostly slowing now, especially in Europe. The composite German purchasing managers' index, or PMI, fell to a six-month low at 48.8 from 50.6 in March. (A reading of less than 50 signals a contraction in private-sector output, the first for Germany since November). April private-sector activity across the 17-nation euro zone continued to shrink at the same pace as March, with Germany slipping into contraction. That was enough to prompt the ECB to cut their main lending rate on May 2, from .75% to .50%. 
Elsewhere in Europe, the sad story of Cyprus that we highlighted in last month's Journal came to an ignominious end, as their Parliament voted to accept the terms of the bailout (really confiscation of wealth) imposed by the EU/IMF. It is a real black eye for private property rights and the rule of law, and is going to lead more people to withdraw assets from banking systems and hoard capital, as opposed to investing in businesses and people.
China's recovery continues to struggle, with HSBC's early read of PMI coming in at just 50.5, barely in expansion territory and down from March.
In the US, the adjectives of "modest" and "slow" continue to apply to the economy.  The all-important GDP Q1 estimate came in much lower than forecast, at +2.5% vs. the expectation of +3.0%, causing the US markets to briefly retreat.
Earnings season has so far been a mixed bag: more companies than expected beat on the bottom line, yet more companies than expected missed on the top line.  This dichotomy reflects continued efforts to squeeze profits via more efficiencies and productivity gains, but in the absence of overall sales gains.  As long as profits must come from efficiency gains, and not from sales gains, hiring will remain subdued.  As of month end, of the 35 companies that had given earnings forecasts for the second quarter, 28 were negative, according to S&P Capital IQ, with only four positive and three in-line.
As we enter May, the popular saying "Sell In May And Go Away" is worth a comment. The graph below visually depicts the average monthly return for the S&P 500 for the modern era:
It turns out that May and June are actually slightly positive, and July is one of the markets' better months. If following the saying, it might be better to restate it as "Sell by Labor Day and Go Away".
As with everything in the markets though, there is no steady, predictable pattern. Historical averages like these are nice to get a feel, but every day brings new challenges to keep us on our toes. We hope you have a great month, and thanks for reading our Journal.
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