Quarterly Report
Quarter Four |
September 30, 2011 |
Late in the second quarter of this year our research saw troubled investing times ahead so we raised considerable cash holdings in most portfolios in mid-June. We wrote to our clients in our second quarter report, “The upcoming third quarter is typically a sluggish trading quarter and we remain prepared for the prospect of continued volatility”. That forecast proved to be accurate.
Our research continued to identify downside potential and in the third quarter, specifically in early-August, we employed further defensive measures and went to mostly cash positions in most client accounts. This defensive positioning has served our clients well as the markets remained very volatile throughout the third quarter, ending the quarter on quite a down move.
For the third quarter, the S&P 500 Index pulled back 14% while the NASDAQ Composite Index and the Russell 2000 Index fell 13% and 22%, respectively. September marked the fifth consecutive month in a row the S&P 500 Index was in the red. Historically five down months in a row is not a good sign for the immediate future for stocks.
International stocks had a rough time as well, with many emerging markets, as measured by the MSCI EEM ETF, falling nearly 25%. Developed international markets also dropped. For example the German Stock market index, known as the DAX, fell 25% for the quarter. Unfortunately for the Germans, they may soon be called to provide enormous amounts of financial support to more than a few European economies.
Keep in mind that the combined economies of the nations that make up Europe represent perhaps the largest regional economy in the world today. The interdependence of these European economies will have a great effect on each other, and therefore the world, for some time to come. Europe will continue to be a drag on the world’s investing markets until the resolution is reached for so many sovereign debt issues. Hanlon clients that profile to invest in equities have no investment in equities today.
Domestic high yield corporate bonds also experienced more than a little weakness during the quarter, falling over 6% as measured by the Merrill Lynch US High Yield Master II Index. Please note that we were only partially invested in high yield corporate bonds for some portion of the quarter and then completely sold them to move to all cash for most of the quarter. Hanlon clients that profile to never invest in equities and instead only invest in bonds have no investment in domestic high yield bonds today.
Perhaps the most noteworthy move in securities prices during the third quarter was the drop in the interest rate on the 10-year US Treasury Bond. It started the quarter at 3.17% and ended the quarter at 1.92%. That is a huge drop in an interest rate! It shows how nervous the investing world is about the risks out there and highlights their need for safety. Oddly enough this rush into US Treasuries occurred while Standard and Poor’s, the credit rating agency, was issuing a downgrade to the United States credit to AA+ from the coveted AAA. This is another example of the Wall Street adage “it’s the market’s opinion that really matters, not what the research sources think, write and say”.
Conservative, patient, and stable investing is critical right now. The markets have been hanging onto every word from politicians both domestically and across the Atlantic in Europe. That is a challenging investing environment, as we all know that comments from politicians can be ever changing, and often times not too well thought out. (Sorry about that Mr. & Mrs. Politician, but at 53 years of age, I have heard enough to form that opinion). Politicians’ thoughts and comments can make the volatility in the markets look calm! So, careful we must be until the investing skies clear and the potential for profits becomes apparent.
As all long-time clients of Hanlon know, these investing periods do occur from time-to-time, and the best way to handle them is to be conservative. High volatility is typically associated with down markets - the type of markets that we are trying to avoid for our clients. But also known by long-time Hanlon clients, sooner-or-later the opportunities will appear. We have a good track record of identifying those opportunities and achieving solid long-term returns, although there is no guarantee. Investing is not about this day, week, month, quarter, or year; it is about successful lifetime investing. Having a proven, trusted investment advisor and money management solutions can guide you through the troubled waters to then benefit from the calm, more profitable seas that will appear in the future. Bottom line – cash is king right now.
Recession Forecast by ECRI
One of the more astute research sources that we follow can be found at www.businesscycle.com. This is the website of ECRI, also known as the Economic Cycle Research Institute. They have an outstanding record of forecasting the economy, using multiple measures built into their models. Here at Hanlon we are primarily chartists, not paying too much attention to fundamental and economic measures. Remember, we think the best research source is the markets and the charts they plot.
But the ECRI is worth the time we invest in following their data and forecasts, if only anecdotally. On Friday, September 30, the ECRI issued a call for a recession expectation for the US economy. This warning corroborates the decline that has occurred in the stock and bond markets since the April 29, 2011 high; that growth is not going to occur at expected rates and that there may be a contraction, again, in the economy.
During recessions earnings for companies can drop approximately 25%, which would mean that instead of earning the $100 expected by Wall Street in 2012, the S&P 500 Index companies may only earn $75. If that is the case then the P/E ratio, a measure of the valuation of the market, would still be high near 16.
If we do, in fact, have another recession soon it will be the first time the US economy has experienced a double-dip recession since the early 1980’s, when a recession occurred in 1980 and then again in 1982. That was the bottom for the equity markets and it launched an 18-year bull market. If it indeed occurs, we shall see how this double-dip affects the markets.
This debt build-up is the controlling factor in today’s investment world. Sooner or later there will be massive defaults to clear out the debts. That is neither unusual, nor unprecedented. There have been many, many times in history where nations defaulted on their debts; it is not different this time! Until that happens we will be hampered by this debt overhang. The methods used by Hanlon Investment Management - tactical and strategic investing - will remain an important investment style that every investor should have exposure to in their portfolio, especially during this period.
We strongly encourage all of our advisory clients to meet with their financial professional at least once a year. As we now approach year end, this is a very opportune time to contact your professional and schedule a time to discuss your accounts, update your personal information and any changes that may have occurred to your objectives.
We remain confident in our abilities to navigate these volatile markets. We also will as usual invest client accounts during the anticipated next investment opportunity to successfully meet the specific investment objectives and risk profile.
Thank you for the opportunity to be of service.
Thank you,
Sean Hanlon, CFP®
Chairman, CEO and Chief Investment Officer
