Markets Break Records in Q1: Now What?

Investors approached 2013 fearing the fallout from the much ballyhooed Fiscal Cliff, that toxic cocktail of $620 billion in spending cuts and tax hikes poised to send the economy into a tailspin absent legislative action.

Lawmakers, concerned about imposing austerity on a weak economy despite its long term salutary effects, maintained most of the Bush tax cuts. Investors cheered, sending the Dow up 5.9% in January, the best first month since 1994.

Despite the postponed sequestration taking effect in March and Cyprus’ banking crisis underscoring Europe’s problems, investors’ embrace of stocks continued throughout the quarter.

The Dow notched an all-time high on March 5, surpassing its previous peak of 14,198 in October, 2007. The broader S&P, weighed down by weakness in Apple, its largest component, finally joined the Dow in record territory on the very last day of the quarter.

The Dow’s 11.9% total return was its best first quarter since 1998. The S&P 500 advanced 10.6%, including dividends, while tech stock weakness muted the Nasdaq’s total return to 8.2%.

Outlook

Near term, several indicators are flashing caution, including an extremely low VIX, or fear indicator, weakness in cyclical stocks, and uncertainty as to the path of fiscal policy.

Bonds and cash continue to look relatively unappetizing. A rising interest rate environment could inflict sizeable losses on certain types of fixed income, including most investments seen as yield plays.

Federal Reserve: When Does it Take the Punch Bowl Away?

A determined Ben Bernanke, head of the Federal Reserve, adroitly saved the economy from a financial crisis following the nationwide housing bubble. By engineering a decline in short term interest rates to near zero and spearheading a program that now buys $85 billion monthly of longer dated debt, including mortgages, corporations and individuals have cut borrowing costs. He’s incented investors to shift into riskier and higher yielding assets.

The good news is that this program is set to continue until unemployment declines from the current 7.7% rate to 6.5%, provided that the inflation outlook does not exceed 2.5%. That suggests that the current market upswing has significant running room.

One risk is that inflation heats up much faster than forecast. Indeed, February’s CPI was 0.7% which, if annualized, is much higher than the Federal Reserve will tolerate.

Moreover, stocks anticipate economic data, probably far faster than the Federal Reserve. By the time the Federal Reserve announces a policy change, markets may have already reacted.

Investors should not be complacent simply because the Federal Reserve has announced no deviation from its easy money policies.

Valuations: Attractive But Not Cheap

Based on such traditional metrics as price to earnings ratios, stocks at 15.4 times reported profits are not overpriced. However, by no means are stocks the bargains of 2009 and by some measures are overpriced.

Investors should not fear markets because they’ve surpassed their October, 2007 highs. Companies today have greater earnings and sales, much lower debt, and a superior dividend yield (2.1% versus 1.8%) than they had at the last peak, so by those gauges markets are a far better buy.

Of course, markets are far pricier than they were at the market’s nadir in March of 2009, when the price to earnings ratio fell to about 13.9 and dividend yields briefly exceeded 4%. The market’s 132% romp in the 4 years since then now requires investors to be far more selective.

Robert Shiller, the renowned Yale economist who was so prescient in calling the housing downturn, looks at stock prices relative to their earnings over the last 10 years. By that measure, stocks look expensive, trading at 22.8 times past earnings versus the historic 16.5, although cheaper than the 27 time earnings recorded at the market’s last peak.

The Shiller approach underscores how variable earnings are. Unforeseen economic issues could easily depress corporate earnings, making the market vulnerable to correction or worse. Fuller valuations compel investors to be far choosier when initiating new stock buys.

Economy: Sub-Par Rebound is Nevertheless a Rebound

While highly muted relative to historical comebacks from a recession, the US economy appears to be improving. Despite a slightly negative GDP print for 2012’s final quarter, a higher payroll tax, and the bite of the sequester, first time unemployment claims recently dropped to a five years low and February saw a surprising 236K job creation tally.

The latest statistics leave little doubt that the housing downturn has all but ended. Indeed, home prices jumped 8.1% in 20 major cities in the last 12 months. Several particularly hard hit cities reported double digit percentage rebounds, led by Phoenix’s 23%. Such appreciation in what for most is their biggest asset fortifies confidence and spending.

Corporations: Weak Confidence Leads to Big Returns for Shareholders

Uncertainty in the board room is causing managers to shelve expansion plans, a big barrier to a more rapid economic renaissance. But, the discretionary cash flows resulting from record high margins due in part to brutal cost cuttings have left companies with large piles of cash. They are returning that cash to shareholders in the form of dividend hikes and stock buybacks, much to the benefit of investors.

The first quarter saw many dividend increases, including a 10% uptick by downtrodden Hewlett Packard. Indeed, $300 billion in dividend payouts are expected this year, exceeding last year’s $282 billion, while February’s $118 billion in announced stock buybacks is the largest single month tally since records began in 1985.

The return of cash to shareholders, particularly in the form of dividends, is helping make stocks the new bonds.

Near Term Headwinds Breed Caution

Wall Street watches Washington warily, and celebrated in Q1 as Washington avoided the Fiscal Cliff. Washington watches Wall Street, too; as the markets and economy climb higher, Washington may be more willing to accept near term austerity to achieve longer term budgetary objectives, and that could prove a headwind.

The agenda includes revisiting the debt ceiling in May and the expiration of the continuing budget resolution September 30. An inability to come to terms or coming to terms perceived as excessive austerity could create volatility.

Higher interest rates could also pose problems. The 10 year Treasury finished the quarter at 1.85%, virtually flat for the quarter but up from the low of 1.38% last summer. With this yield remaining below the S&P 500’s dividend yield of 2.16%, a rare occurrence, these low rates provide a tail wind to the market and incentive to rotate from bonds into stocks.

Rates could climb quite quickly. Just 23 months ago the 10 year Treasury was at 3.67%. Higher interest rates are never a positive, but can be better rationalized to the extent due to greater loan demand as opposed to inflationary pressures.

A sounder European economy gave monetary authorities there courage to support a "bail-in" as opposed to a bail out when Cypriot banks teetered. The bail in imposed losses of 40% on substantial depositors. This turn of events cannot inspire confidence and we cannot be sure that loss of faith won’t end up at the doorsteps of US banks and markets.

Investment Strategy

A stay the course strategy was vindicated in the first quarter. Even Warren Buffett failed to pick the bottom of the last down turn as reflected by his too early forays into General Electric and Goldman Sachs. Don’t expect to call the twists and turns of the next 12 months. And there will be many.

Rebalance into shorter duration high quality fixed income to the extent the recent rally has left you overexposed to stocks. Reaching for just a little more yield at the price of substantial increases in maturity or credit risk doesn’t make sense. Indeed, be wary of all investments labeled yield plays.

Market dips can be profitably met with buying. Don’t chase consumer staples names, which led the first quarter rally. Paying 20 times earnings for stocks growing at mid-single digit percentage rates doesn’t make sense.

Overseas stocks are cheaper than domestic ones and, depending on risk tolerance, are worth considering. Given that up to 50% of the S&P’s revenues come in from abroad, it probably makes sense simply to look for the cheapest way to get exposure to earnings and cash flow without regard to legal domicile. Both China’s and Brazil’s economies are growing faster than the US, yet their markets trade at cheaper valuations.

Many high quality technology companies trade at bargain valuations and offer not only generous but growing dividends.

Cisco just boosted its payout 21%; look for Apple to make a headline grabbing commitment to returning more of its cash hoard to its owners.