On the heels of the Federal Reserve’s quantitative easing, the equity markets surged to their best December performance in 20 years. Since the Fed announced QE in August, the S&P 500 has rallied by 24% as market participants (note my avoidance of the word “investors”) gobbled up risk wherever they could find it – from commodities to stocks. For December, the Dow Jones UBS commodity index tacked on 11%. And for the year, small cap stocks (as measured by the Russell 2000 Index) gained over 26% — besting its large cap counterpart by 12% for the year. A full 80% of the S&P 500’s gains for the year came in the third quarter.
It seems that market participants are fully engaged with the concept of the “Bernanke Put.” The idea of the Put being that the Federal Reserve will do whatever is necessary (in whatever amount necessary) to prevent a decline in the value of risk assets. A discussion of the wisdom of the Bernanke Put is beyond the scope of this post, but would make for interesting discussion during our monthly conference call.
The gains in risk assets came largely at the expense of fixed income assets, as December saw net capital inflows from fixed income fund to equity funds for the first time in two years. Declines in the value of 10-year Treasury Bonds pushed yields up by over 16% in December, to 3.33%. Nearly all bonds shared a similar fate, with losses in mortgage backed securities, emerging market debt, investment grade corporates and TIPS. World Inflation Protected Securities (WIP) stood alone among bond winners; posting a 2.6% gain in December.
One theme overrode all others during the market’s fourth quarter rally. That is, low-quality, low-yielding, higher risk assets performed demonstrably better than their higher-quality, dividend-paying, less risky counterparts. This is not so much a matter of opinion, as an objective look-back on the market’s embracing of cyclicals, small-cap stocks, commodities and stocks characterized by high betas (sensitivity to market risk) and low stability of earnings. In the overused parlance of market pundits, “The risk trade is on.”
During times like these, which I would characterize as speculative (unless you believe the cumulative value of the entities comprising the “market” are fundamentally worth 25% more today than they were less than 100 days ago), we continue to source our returns from non-beta investments. The investment choices confronting us under the current circumstance boils down to a simple dichotomy: Momentum or Fundamentals. We have always been, and will continue to be, fundamental investors. We like the fundamentals of mergers and acquisitions for 2011. We like the fundamentals of energy and agriculture. We like the fundamentals of senior floating bank loans. And, in what might be construed as a contrarian theme, we like the fundamentals of high-quality, dividend-paying, multi-national, large cap stocks. Those are the themes we will be pursuing as we enter 2011. We will not, despite the visceral urge to do so, increase our beta in an attempt to “ride the wave.”