The tremendous stock market rally since March has attracted the lion’s share of financial headlines. One of the most dramatic advances in U.S. history fully deserves that favorable attention. Far less well publicized was the fact that most other asset classes have similarly provided remarkable six-month gains. In fact, the best performers have been the poorest quality assets like the lowest rated junk bonds. In most cases the extent of the bounce in the rally is inversely related to the extent of the preceding decline. Nonetheless, most equity indexes remain below where they were a year ago.
A number of clients have asked why we are not more enthusiastic about both corporate and municipal bonds. Frankly, if we had foreseen that investors would have been so quick to reaccept high levels of investment risk, we would have made substantial commitments to both the stock and non-government bond areas. Unprecedented amounts of government stimulus have succeeded in reassuring investors in both the equity and debt markets. Simply stopping the bleeding from the credit crisis a year ago has gone a long way toward bringing us back to a more normal business environment. That we have experienced no similar large scale disasters since has fed the growing positive investor attitude. We are not, however, out of the woods.
Serious strains remain in this country’s financial system. Many of our largest banks are alive only because of government assistance. We can’t know yet how well the system will function once the government’s assistance is withdrawn.
A great many municipalities are severely strapped because of declining tax revenues. Many are likely to default on their tax exempt bonds in the next few quarters.
While corporate earnings have fallen precipitously from their peaks, sharp cost cutting has prevented an even more significant decline in earnings per share. It will be much tougher to replicate such cost cutting in quarters to come. Further enthusiasm for stocks will flow only from improvement in earnings — likely only if revenues start to grow. With unemployment yet increasing and consumers still exhibiting frugal tendencies, growing revenues may prove elusive. As Warren Buffett has warned, a great many corporations have derivative-laden balance sheets that do not adequately reveal the level of risk assumed. If business conditions slow as the effects of government stimulus fade, we anticipate a series of corporate defaults, which would likely damage corporate bond prices even for stable companies.
Some people have suggested buying corporate bonds with just a few years to maturity. That could prove to be a sound approach, but we prefer to wait at least several more months. The stock market will not grow to the sky without at least occasional meaningful corrections. We anticipate that when some of the current exuberance fades, we will simultaneously experience an expansion of the spread between the yields of corporate and government bonds. If the economy does not fall into a second leg of this recession, we may indeed find some attractive corporate or municipal bond investments, especially those with relatively short maturities.
Bond prices may fluctuate with the fortunes of the U.S. dollar, which is significantly oversold. There is virtually unanimous opinion that the dollar can only decline from here. Unlike most investment managers, we expect at the very least a meaningful technical rally soon, even if the dollar is fated to go lower in the longer term. Since most asset classes have rallied as the dollar has declined in recent months, we think likely that a surprise dollar rally would put pressure on the prices of stocks, bonds, oil, gold and other commodities. We will take another look at short maturity bonds once we see how they behave in their first pullback phase, which could coincide with a dollar rally.
Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.