During the quarter, MCS cautiously expanded its stock buying, depending on client circumstances. The move into stocks had been planned for months and was not a result of trying to get in on 2012 first quarter stock gains.
The big gains actually held back our willingness to commit to equities, because higher stock prices are less attractive. The increased allocation to stocks was driven by two considerations: 1) a scarcity of attractive bonds, and 2) a strategy to mitigate a potential decline in bond prices that would result from a gradually improving economy. Stocks should go up in value if economic growth is sustained and inflation remains modest. Most of the research I read indicates that equity valuations are OK – perhaps a tad expensive by some measures, but, compared with low bond yields, stocks are a reasonable alternative.
Nevertheless, and as you probably know, the global economic outlook is very uncertain. The first quarter saw Eurozone fears of increasing government default risk subside (causing the big relief rally in stocks). Now, midway into the second quarter, some of that fear is back as the market turns its attention to Spain. During the first quarter of 2012, 10-year U.S. Treasury bond yields rose from 1.9% to 2.4%, only to come back down to below 2% in mid- to late April on fears of a slowdown in U.S. and global economic growth.
This high-frequency, bipolar market condition of Risk On (buy stocks, sell bonds) vs. Risk Off (sell stocks, buy bonds) makes strategy implementation difficult. Such flip flopping would normally encourage the prudent investor to hold more money in short-term money market funds. Unfortunately, because money funds offer near zero nominal return and a negative return after inflation, parking your money in money funds and waiting for great buys has a steep price.
MCS client returns for the first quarter averaged 1.92%. We did not keep up with the stock market’s return because that is not our strategy. Over more than a decade, we have achieved stable returns by shunning a heavy equity allocation. That said, we will carefully increase our stock allocation, as we are now, when my asset class risk/reward analysis indicates stocks will likely offer reasonable returns compared with bonds. None of this changes my previous analysis that we are now living in a more economically volatile, higher risk/lower return world.
The municipal bond market is in the early stages of potentially profound changes. Two high-profile bankruptcy/near-bankruptcy situations – City of Stockton, California, and Jefferson County, Alabama – will challenge some fundamental assumptions about general obligation bonds. These cases will test the meaning of “full faith and credit” in the municipal market. When local officials make big financial miscalculations, at what point can they turn to bondholders to share the pain? Last year, Rhode Island’s state legislature passed a law ensuring that bond holders will be paid in full, while union contracts for wages and retiree health benefits and pensions could be renegotiated to restore the municipality’s solvency. Jefferson County is taking a totally different tack to address their financial problems, asking that bondholders take partial payment for their debt and share the pain while resisting raising already astronomical sewer rates. My observation is that revenue bonds (paid by dedicated revenue streams such as a sales tax) may in many cases be more secure than some types of general obligations that rely on politically unpopular tax increases to restore a municipality’s financial condition. I will be watching this evolving area closely, because it creates both risks and opportunities for our clients.