2011 Q2 Preview: Cresting the Wave

As we emerge from the cold of winter, investment markets continue to run hot.  Despite the risks and volatility pressing markets in 2011 Q1 – social unrest in the Middle East, an ongoing debt crisis in Europe, the tragic earthquake in Japan, a U.S. economic recovery that is still struggling to gain traction, etc. – virtually all asset classes ended the quarter solidly higher.  This performance must be taken with a healthy grain of salt.  After all, stocks were lower for the quarter as recently as March 16.  But the market strength in the face of these challenges is notable.

As discussed in previous commentaries, the key behind this market strength remains the $600 billion “Quantitative Easing 2” (QE2) stimulus program from the U.S. Federal Reserve.  This program set to end on June 30, 2011, which is the last day of Q2.  As a result, is necessary it keep a sharp eye on the implications of the end of QE2 for each asset class as we move through the current quarter.

The following is a review and preview for each of the major asset classes:

Stocks – The upward move in stocks since last summer has been driven almost exclusively by QE2.  And this benefit continued in the first quarter, with stocks up over +5%.  Performance was particularly strong in U.S. Mid-Cap stocks, which were up over +9%.  But stocks are likely to face increasing pressure as we approach the end of QE2.  Stocks dropped by nearly -20% in a matter of weeks following the end of QE1, and this is a fact not at all lost on the market – investors will almost certainly be anticipating the end of QE this time around.  Just as Fed Chairman Ben Bernanke’s speech in Jackson Hole on August 27, 2010 confirming QE2 marked the start of the rally in stocks, his first ever monetary decision press conference coming up on April 27 potentially confirming the end of QE2 may very well mark the peak in stocks and a shift to the downside.  Stay tuned.

High Yield Corporate Bonds – High yield bonds enjoyed a nearly uninterrupted move higher in the second quarter, rising nearly +4%.  Although the asset class has “bonds” in its name, high yield bonds actually trade more in line with stocks but usually with less volatility.  In short, high yield bonds are more like “stocks lite”.  But unlike stocks, high yield bonds continued to move steadily higher following the end of QE1 last summer following an initial pullback.  With companies in this category continuing to stockpile cash and paying down debt, it is reasonable to expect that this category may hold up relatively well again this time around.

Gold & Silver – The money printing by global central banks including the Fed has raised concerns about the value of the U.S. dollar and other fiat currencies.  This has led investors toward hard assets such as gold and silver as a store of value.  Gold has spent the last few months consolidating gains and only recently experienced an upside breakout in the first few days of April.  Silver, on the other hand, is now fully engaged in a mania phase.  Overall, silver was up +22% in the first quarter, is up +8% already in the first few trading days of April and has nearly doubled since Bernanke’s August 27 Jackson Hole speech last summer.  Manias like this usually end badly regardless of the fundamental reasons behind the story, so a very close watch is necessary in the coming weeks for even the first signs of any inflection point in the white metal.  And while both gold and silver performed well following the end of QE1 last summer, gold will likely be the preferred position to emphasize in working to navigate the post QE2 environment.  Caviat: the flood of central bank liquidity has clearly played a role in driving metals higher during QE2, so any subsequent post QE2 draining of liquidity may end up pushing gold to the downside.

Investment Grade Corporate Bonds – Investment Grade Corporate Bonds continue to provide steady performance since the days following the outbreak of the financial crisis in late 2008.  Just like their high yield counterparts, higher quality investment grade companies are also flush with cash and working to pay down debt.  But unlike their high yield brethren, this category trades independently of stocks.  Investment grade corporate bonds have generally risen when stock markets were rising over the last two years, but they’ve done even better when stocks were falling.  They gained +7% when stocks dropped by -20% after QE1 last summer, and they currently represent a decent value heading toward the end of QE2.  While the potential for rising inflation is a threat for this category, investment grade corporate bonds still provide favorable portfolio diversification benefits overall.

Treasuries – This category has essentially become a trade against stocks.  In short, when QE is on and stocks are going up, U.S. Treasuries are typically trading sideways or selling off.  And when QE is off and stocks are going down, U.S. Treasuries have rallied.  As a result, Treasuries may offer the potential for a short-term trading position heading into the post QE2 market.  Otherwise, they remain richly priced and offer little long-term appeal given the current fiscal state of the U.S. government and rising inflation pressures.  Caviat: if the U.S. economy fell back toward recession later in the year, Treasuries may provide more interesting total return prospects.  But this is still a big “if” at this point.

TIPS – Treasury Inflation Protected Securities (TIPS) are a special category of U.S. Treasuries that are backed by the U.S. government but are also adjusted for inflation.  As a result, they trade on their own path separate from the broader Treasury market.  TIPS have traded steadily higher since the days following the financial crisis in late 2008.  And unlike traditional Treasuries, they’ve traded higher both during stock rallies and stock pullbacks – TIPS gained +4% when stocks sold off after QE1 last summer and are up another +4% since.  Mounting concerns about inflation have added to the appeal for TIPS, and these concerns are not likely to dissipate with gasoline prices heading north of $4.00 a gallon this summer.  Despite all of these positives, these bonds are still issued by the U.S. government.  If concerns about the U.S. fiscal situation or the government’s handling of it persist, investors could start to become wary.

The bottom line – Investment markets have performed well in recent months but may be approaching a major inflection point with the end of QE2 approaching at the end of June.  As a result, increasing volatility should be expected as we move through the quarter.  Also, an increasing priority will be to focus on investment categories that fundamentally make sense and are also positioned to rise in a post QE2 environment.

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.

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