In the film classic The Wizard of Oz, Dorothy follows the yellow brick road to see the magical Wizard, who supposedly has the powers to grant her wish to return home. But upon her arrival in the Emerald City, the Wizard’s curtain opens to reveal nothing other than an ordinary man carrying out a charade. Investors find themselves taking a similar look behind the market curtain as we move into the third quarter of 2011.
The Fed’s stimulus program – known as QE2 – came to an end on June 30. The idea behind the Fed’s effort was to provide support to the U.S. economy until it had recovered enough to stand on its own. Back in April 2010, investors had their first opportunity to look behind the market curtain when QE1 came to an end. And they did not like what they had found. The economy remained far too weak and the threat of another financial crisis was emanating from Europe. Stocks quickly plunged as a result. But unlike in the Wizard of Oz, the curtain was quickly pulled shut with the introduction of QE2. The message from the Fed – come back a year from now in June 2011 and the magical economy you’ve been waiting for will finally be here.
Upon drawing the curtain back a second time in July 2011, investors are still not bound to like what they’ve found. The economic recovery remains sluggish with job creation over the last few months all but stalled. The urgency of the crisis in Europe has spread from smaller countries like Greece to much larger nations like Italy. And all the while the U.S. government is deadlocked in a debate over raising the debt ceiling, only adding to the uncertainty.
Stocks have been remarkably resilient to this point in the face of mounting risks. But for how much longer? The stock market has a lot of air under it, as strong gains over the last few years have been justified by expectations that the economy would eventually recover strongly enough to support it. Unfortunately, this has not been the case. And the Fed’s QE stimulus that has helped lift stocks higher to this point has now gone away. As a result, it could be a very difficult time for stocks in the coming months. And the same is true for industrial and agricultural commodities for all of the same reasons.
Fortunately, stocks are only one of many asset class categories available in investment markets to capture opportunity and generate strong returns. And a variety of asset classes have attractive prospects as we move on in the Post QE2 marketplace. I’ve provided a brief summary on each below.
Gold – Although the yellow metal has risen strongly for many years, further upside is likely as long as global economic instability persists and major currencies such as the U.S. dollar and the euro suffer from a lack of confidence.
U.S. Treasuries and Treasury Inflation Protected Securities (TIPS) – If stocks come under pressure, particularly due to a weakening global economy or the threat of a crisis in Europe, investors will likely continue to migrate to the relative safety of Treasury bonds. TIPS are up +7% so far in 2011 and Treasuries have been rallying since February and are already up +1% in the first few days of Q3. These positions have a generally short-term focus, however, particularly if the Fed starts talking about QE3 in the coming months.
Non-Financial Preferred Stocks – These are essentially bonds from electric utilities that trade like stocks on an exchange. They have yields in the range of 6% to 8% and have performed well both during periods of market calm as well as when the market has entered into pullback and even crisis phases.
Investment Grade Corporate Bonds – A consistently strong performing asset class regardless of whether stocks are in rally mode or in a pullback phase. Highlighting this point, the category is up roughly +40% since the beginning of the financial crisis while stocks are still working their way out of negative territory. Corporations are flush with cash, which bodes well for future outperformance. However, if the situation currently brewing in Italy breaks out into another full-blown financial crisis, allocations here will likely be reduced or sold altogether until the dust settles.
High Quality Defensive Stocks – While the current outlook for stocks in general is currently poor, certain sectors are set to perform well. These include companies from the Food, Household Products and Utilities industries. Regardless of how the economy performs, people are still going to eat, use soap (at least we hope) and turn on the lights. Of course, just like with corporate bonds, if a full-blown crisis phase erupts even stock positions in these defensive industries will likely be exited until stability returns to markets.
So although stocks in general may come under pressure as we move through the summer, many other asset classes that even includes some selected stock industries are set to perform well.
It promises to be an interesting summer for investment markets, and I will keep you updated along the way.