The very good beginning to earnings’ season of just a month ago has given way to concerns over sovereign debt in Europe (still) and even here in the US (courtesy of debt ceiling debate). The increase in volatility over the past few weeks is reminiscent of the gyrations of 2008, with a twist: the daily moves of over 4% for four straight days were unprecedented, with the week finishing slightly lower and all investors a bit greyer. The likelihood of a recession in the US has increased, especially in the face of a weak GDP report (combined with lower revisions of previous quarters). The lower rated US Treasury bonds (by only S&P) have been bid well higher in the face of both the poorer economic outlook as well as problem sovereign debt issues. As is usual with these monthly pieces and more so now given the huge market swings and global changes – the question of what should be done in a portfolio is first and foremost in everyone’s mind.
When looking at investment choices, the first place to look is not at the various indices themselves, but the relationship between the various indices. This works well no matter what your overall investment objective is: beating an index, staying ahead of “zero” or just preserving wealth. The first look will be at the basic decision – do I buy stocks or bonds?
The above chart is the relationship (or relative strength) between the SP500 and the Lehman Aggregate Index. Beginning early in 2011, bonds began to outperform stocks; even though the first half of the year was good for stocks…it was even better for bonds. Obviously, that relationship only intensified with the guns of August being fired in Washington around the debt ceiling change. Running through the data is a simple 25 week moving average, highlighting trend changes. Thus, the decision of being in stocks vs. bonds would have favored bonds for much of this year and as long as that relationship persists (bonds outperforming stocks) a defensive posture is warranted. Now many who are technically inclined would look at the above chart and note that each period of bond outperformance that has occurred has failed to achieve the heights of the previous period. The first spike is the fall of 2008; the next is summer 2010 and now the current spike. It will be important to keep an eye on this relationship over the next few weeks to see if bond yields begin to rise (and prices fall) as stocks begin to recover from their swoon.
No matter which equity index you may look at, the relationship between the index and bonds is similar. Although some “broke down” earlier (like emerging markets) or maybe later (like small cap), the trends across equity markets are all the same, bond performance has dominated stock performance. In order to get better than bond performance in the “equity” market, investors have had to move toward the commodity markets, which have their own very volatile periods of time as well…just look at silver’s May swoon of over 20%.
In short, looking at these relationships is nothing more than following the money. Whether looking at the larger asset classes (large, small, bonds, stocks, international etc) or industry groups within the SP500, a review of the relationships is helpful in seeing shifts in market sentiment that may forecast a larger change in the markets.
A few charts to illustrate:
The above chart is that of the Consumer Staples Spider (XLP), a weighted sub-sector of the SP500 index traded as an Exchange Traded Fund (ETF). The far left is the market decline of 2008, where Staples did very well vs. the SP500 and then beginning in April 2009 the sector performed poorly as compared to the market. What is lost on this chart is the absolute performance of XLP. The ETF did fall during 2008, it did rise in 2009, but against the broad SP500, the XLP lost less in ’08 and didn’t make as much in 2009. Further, if you look at the XLP and compare it to the characteristics of the relationship between bonds and stocks above, the relationships and time frames are very similar. So the message in the markets was confirmed when looking at defensive type of stocks, investors began getting defensive in mid-late 2007 and aggressive during 2009 and defensive again so far this year.
Next, let’s look at a more aggressive part of the market, the industrial sector –which is more closely tied to the economic cycle of the economy.
The XLI is the ETF for the industrial portion of the SP500. Again, weakness was beginning to show up early in 2008 and fell off with the market after mid-year 2008. After bottoming in March, a clear trend line developed early in fall 2009 giving the index an 18 month period of solid outperformance of the SP500. The long-term trend line was finally broken in May 2010, coincident with economic data showing the economy was beginning to slow.
Rather than trying to guess where the market is going, I can readily discern what parts of the market or what asset class is doing well and shift/overweight investments in those parts of the markets to either reduce my exposure to potential losses or to gain an advantage when compared to the broader market (as represented by the SP500).
One question that may come up when looking at the above discussion is “how can you invest in treasuries that yield next to nothing? They (yields) are certain to go higher”. While that may be true, what I am uncertain about is the performance of the SP500 over that same horizon. Even if bonds remain stable while stock prices fall, the holdings in bonds would be looking good. Since this a relationship chart, bonds only lose to stocks IF stocks perform better than bonds. Certainly other asset classes or sub-groups can be used in looking at these relationships, including oil, gold, currencies or whatever the investment of choice may be in your portfolio. The goal of this particular exercise is to recognize when the party maybe ending and getting out before the police arrive!
