20120510 KCM Commentary
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  • 1. May 10, 2012Greetings,As the calendar turns to the month of May, school children become restless in anticipation of summer. Ina similar manner, markets have returned to their wacky, nerve-rattling ways, with headlines in Europe andeconomic concerns domestically again resurfacing. Below, we summarize the events unfolding over thelast few weeks which have contributed to the negative change in the investment market outlook.Sell in May & Go AwayAs discussed in Stock Trader’s Almanac, the “sell in May, go away” phenomenon has returned in 2012.More than ever, the media seems to be picking up on this seasonal trend and is reporting on it.Conversely, investment houses and mutual fund companies are publishing whitepapers and hostingwebinars enumerating reasons as to why investors should ignore the phenomenon this year. In ouropinion, this seems self-serving as they are encouraging you not to sell their product.Volatility returned during the summer months of both 2010 and 2011, and markets weakened and gaveback much of their year-to-date gains. In 2010, we dealt with the “flash crash” and a tumultuous summer.The market decline was only saved in late August with the Fed announcement of their next round ofquantitative easing which resulted in the “risk-on” trade with risky assets taking off. In 2011, marketssold off immediately with the turn of the calendar to May, and investors were in for a “stomach in themouth” rollercoaster ride culminating with the Washington budget standoff and news media’s “7-6-5-4...”countdown of the U.S. Treasury default. Once we passed that hurdle with a budget agreement, marketsentiment was whacked by the news of S&P’s downgrade of the U.S. debt from AAA rating. Whilestruggling to move higher during the summer months, in both years, the market found its legs by the falland put in most of the yearly gains during the last months of the calendar year. Essentially, an investorcould have sat on the sidelines until the last part of the year and gotten all the market gains as measuredby the S&P 500 for 2010 and 2011. As of today, 2012 is looking like “déjà vu”.We are mindful of the “Best Six Months” / “Worst Six Months” phenomenon, and have reduced risk inour portfolios to seek safer grounds for the unfavorable time period we are currently in. One investmentwe like to use in this unfavorable period is the Doubleline Total Return fund which is managed by one ofthe best bond managers in the business, Jeffery Gundlach. We continue to believe that investors willwant to be paid, and as a result, we also like high-yield bonds, preferred securities, and real-estate incomeinvestments.A Review of the ChartsIn the following charts, we will take a look at several of the major equity indexes. Markets began movingsideways (consolidating) in mid-March, before beginning their recent mild declines. Because Apple isnot a component of the Dow Jones Industrial Average, the Dow held up better than both the S&P 500 andthe Nasdaq as Apple, which rose nearly 50% in Q1 2012, began pulling back. Apple has simply becomeso large that it is difficult for markets to move higher while Apple declines in value.Currently, markets are testing their 100-day moving averages. As of today, the Dow, S&P 500, andNasdaq all remain above these key technical levels. The same cannot be said for international markets,where the EAFE index (developed international markets) is getting smashed on the European woes.Investors are running away from Europe with the crisis spreading to Spain & Italy, and a declining Eurofurther magnifies the decline in U.S. dollar terms. Kenjol Capital Management • 7000 N. Mopac Expressway, 2nd Floor • Austin, Texas 78731 866.453.6565 • 512.506.9395 • info@kenjol.com Page 1 of 7
  • 2. Dow Jones Industrial Average:S&P 500: Kenjol Capital Management • 7000 N. Mopac Expressway, 2nd Floor • Austin, Texas 78731 866.453.6565 • 512.506.9395 • info@kenjol.com Page 2 of 7
  • 3. NASDAQ 100:MSCI EAFE (International): Kenjol Capital Management • 7000 N. Mopac Expressway, 2nd Floor • Austin, Texas 78731 866.453.6565 • 512.506.9395 • info@kenjol.com Page 3 of 7
  • 4. The coming days and weeks will tell us whether U.S. markets will follow European markets lower. Asfor now, markets have sold off on any bad news in May while not being able to breakout higher on signsof optimism. The concern is the herd mentality where selling begets selling which begets more selling.With that in mind, we wanted to review this chart from our friends at J.P. Morgan which shows calendaryear returns for the S&P 500 by year (grey bar) along with the corresponding intra-year decline asrepresented by the purple dot below it. It is interesting to see that from the period of 1983 – 1996, therewere only three years (1984, 1987, and 1990) when the decline was double digits. Stocks rewardedinvestors for the risk of the downturns. Starting in 1997, the intra-year declines became more fierce forthe equity investor as the stock bubble began to pop. For the 14 year period from 1983 – 1996, theaverage intra-year decline was a -10.2%. For the 15 year period 1997 – 2011, the average intra-yeardecline has almost doubled to -18.3%. Again, the equity investor has gotten less return and biggerswoons with a stunning -47% drawdown in 2008. Much of this underperformance has been due to anexpensive market by the end of the 1990’s, and a reversion to normal priced markets with today’s market.Accordingly, the challenge for investors and investment managers is how to appropriately navigate thedoubling in intra-year declines and volatility. How do we control risk? Repositioning to safer bondinvestments during part of the year is one way but not a comprehensive solution.Corporate Earnings, GDP Growth, Employment, & QE3?During April, the majority of corporations reported earnings for the latest quarter. While earnings reportswere good and in many cases better than expected, markets were unable to push higher as reflected in theprevious charts given two primary factors looming over the market. Notably, the European situation hasreturned to the front-page headlines with concerns again arising in Greece, Spain, and Italy. Kenjol Capital Management • 7000 N. Mopac Expressway, 2nd Floor • Austin, Texas 78731 866.453.6565 • 512.506.9395 • info@kenjol.com Page 4 of 7
  • 5. In addition, softer economic news including the latest revision down to Q1 2012 GDP to 2.2% from apreviously announced 3.0% has reignited economic concerns domestically. Regional economic reportssuch as the Chicago Purchasing Managers Index (PMI) fell further than expected. However, this negativedata was followed by the national ISM manufacturing report which significantly surpassed expectationsand renewed investors’ hopes that the U.S. economy was holding up despite the European slowdown.More concerning is the employment numbers which have disappointed in recent months. Both ADP andgovernment reported numbers came in below expectations and gave rise to the fear of a double-diprecession as is currently being experienced in European countries on the back of their austerity measures.As we have said for the last two years, while there is a chance of a double-dip recession, the probability isvery low at this point. In our opinion, the economy is just muddling along, but a slowdown from theselow growth levels does not appear imminent. As such, it will remain difficult for the jobs picture tosignificantly improve in the current environment.With the less than spectacular economic data, the Fed will continue its mandate to keep interest rates lowand do everything possible to keep mortgage rates low as well. Again, if you have not considered arefinance of your existing mortgage, now is the time to do so with rates again near historic lows.Notable bond managers such a Bill Gross, Jeffery Gundlach, and Dan Fuss whose firms collectivelyoversee about $1.5 trillion in assets now expect the Federal Reserve to conduct a third round of bondpurchases as signs of strength in the U.S. economy fade and the European sovereign-debt crisis continues.Why is this important for the markets? At a time when Roger Clemens, “The Rocket”, is on trial forperjury for his statements about performance enhancing drugs, the financial markets are looking for thenext clues about the prospects of the Fed’s “performance enhancing” stimulus in the form of QE3(quantitative easing). The chart on the following page reflects the performance of the S&P 500 with eachround of Fed “rocket fuel”. Equity markets clearly traded higher during QE1 and QE2. Once each roundof quantitative easing came to an end, markets flopped until the next dose of stimulus was announced.Notably, markets jumped in late August of 2010 on the announcement of another round of stimulus evenbefore the program began.As each program ends, the market anticipates the conclusion and investors start to reduce risk and equityexposure. We are again coming to a close of Fed action, the end Operation Twist where the Fed has beenbuying long-dated bonds to drive down interest rates and the related yield curve. While this is a boon tothose refinancing both at the consumer and corporate level, it decimates the income-oriented investmentsthe retired generation relies on. While speculation of QE3 continues, we will probably not hear anythingabout action until the June Fed meeting. If nothing is proposed, markets may well selloff indisappointment. The question is does the U.S. have a liquidity problem or a confidence problem? Weargue the latter, especially considering the fiscal cliff and pending tax rate changes looming in 2013.European MessThe best supporting actress award for a dysfunctional market goes to the European debt crisis. While themarket ignored Europe during the first quarter, the issue came back to investor’s minds in March with theGreek debt swap vote. Only two months later, investors now holding new Greek debt must questionwhether they will be repaid in Euros or in devalued Greek currency with the return to the Greek drachma.There are many camps on what should be done to fix the problem and whether it can be fixed. We are ofthe opinion that you cannot cut your way to prosperity. Germany is in the austerity camp, but the peoplein countries suffering through austerity and recession are changing their elected officials. Any businessowner will tell you that you must increase revenues and decrease expenses. Kenjol Capital Management • 7000 N. Mopac Expressway, 2nd Floor • Austin, Texas 78731 866.453.6565 • 512.506.9395 • info@kenjol.com Page 5 of 7
  • 6. Elections this past weekend shifted the political landscape in Europe leaders again as the populace tries todeal with the debt crisis and austerity measures. Last Sunday, socialist candidate Francois Hollande wonthe French presidential election over incumbent Nicolas Sarkozy. This raises the level of risk in Europespecifically between France and Germany. Holland has been very critical of the European Union’sresponse to the debt crisis, has questioned the role of the European Central Bank (ECB), and voiced hisdesire to renegotiate France’s support for the sovereign rescue funds. Now, the market believes under hisleadership we will have more political fighting among the European leaders on how best to solve the debtcrisis amongst the Eurozone member nations.All in all, member nations have been working together in good faith to keep the EU together. If Hollandetries to renegotiate many of the pacts France agreed to under Sarkosy’s leadership, it could underminemany of the accords already established and amplify the tension between policymakers, ECB, andpolitical relations among many of the other EU members. A possible World War III? And what doinvestors hate? Uncertainty! This is essentially what we now have with France under new leadership.With Greece a lost cause, investors are keeping their eyes on Portugal as well as the larger Spain andItaly. In the chart below, notice that Portugal’s rates today are at the same place Greece was a year agoand we know how that turned out. The question will be whether Portugal can roll their debt or whetherinvestors will shun that debt just like they did on Greek debt last summer. The risk for the markets is thatthe amount of debt becomes larger and harder to roll without multi-central bank intervention.Of greater concern is the yield of Spain and Italy’s 10-year bonds. Spanish yields remains right at the 6%level (6.08% close yesterday) while Italian yields closed slightly lower yesterday at 5.60%. The belief forinvestors is that as long as Spain and Italy remain below 6% and contained, those countries may haveenough time to implement the structural changes needed to place both countries on sound footing. Thisproposition is very much in jeopardy. Kenjol Capital Management • 7000 N. Mopac Expressway, 2nd Floor • Austin, Texas 78731 866.453.6565 • 512.506.9395 • info@kenjol.com Page 6 of 7
  • 7. Looking AheadWe mentioned in March that the summer would be choppier. We really only have two choices with theenvironment handed to us. The first is to tie ourselves to the mast and sail through these choppy watersknowing that a better and smoother day will come (in the fall or with announcement of QE3?). Thesecond option is to reduce our equity exposure and increase bond holdings. We have chosen the latter.While that doesn’t lend itself to big gains, it is more about preservation until a more favorableenvironment unfolds.Again, we do expect markets to push higher as we get into the fall. We could see dramatic movespending the presidential election – at least for now we know who the two candidates will be for the fallelection. It is sure to be an ugly campaign and presidential election.Thank you again for your business and continued support. Please call or email us if you would like todiscuss your personal situation further.Regards,Kenny Landgraf & David Levy Kenjol Capital Management • 7000 N. Mopac Expressway, 2nd Floor • Austin, Texas 78731 866.453.6565 • 512.506.9395 • info@kenjol.com Page 7 of 7