Opinion and Investing Column

KIM: Markets start strong in '12, but be ready to 'tie a knot'

February 4, 2012

KimWe are pleased that the recovery of the U.S. stock market that began during the fourth quarter of 2011 continued into January. Looking back, last year was plagued with disasters created by Mother Nature and man alike. Investors were subjected to periods of panic and extreme volatility. Daily volatility increased substantially, with the Standard & Poor’s 500 Index experiencing a move of 1 percent or more on 96 days (more than a third of all trading days).

Investors abandoned the markets in droves, perhaps permanently. Investment Company Institute data showed U.S. stock mutual funds experienced net redemptions of $131.6 billion in 2011. Net redemptions from 2007 to 2011 totaled $466.1 billion. Bond funds, on the other hand, had net purchases of $128.6 billion in 2011 and a total of $888.3 billion from 2007 to 2011. This represents a seismic shift of assets fleeing stocks and rushing into the perceived safety of bonds.

As contrarians and value investors, we have found more long-term value in assets that are being shunned versus assets that are now in vogue. In fact, we’d argue that bonds are more risky than stocks. We’re not Pollyanna, but we don’t think the world is in a period of perpetual economic decline. Although growth hasn’t been as consistent as many would like, we’re encouraged by recent trends. It’s indicative of pervasive pessimism that signs of improvement are often dismissed as a “false dawn.”

The Leuthold Group recently published a study examining the long-term performance of stocks and 10-year U.S. government bonds, comparing total returns to see how the relationship changed.

One of the central tenets of asset allocation is the assumption that equities will outperform bonds, especially as the holding period is increased. What happens when this usual relationship is turned on its head?

Reversion to the mean and the return of historical relationships are powerful forces. Leuthold’s study showed that when these anomalies occur (i.e. bonds outperform stocks), it sets the stage for a return to more normal relationships. Thus, history suggests stocks should again become the better long-term performer.

According to Leuthold, the 20-year stock/bond performance differential has fallen to negative on only three occasions since 1926: in the periods ending in 1933, 1949 and March 31, 2009.

The first two times it happened, the ensuing five-year periods saw the stock/bond performance differential snap back to sharply positive territory. Bonds handily outperformed stocks in 2011, but stocks still have done better than bonds since the March 31, 2009, low. That said, the 20-year performance differential as of the end of 2011 ranked in only the 15th percentile. Thus, the odds favor stocks going forward.

Bonds also have been in a 30-year bull market. The yield on the 10-year U.S. government bond was 15.84 percent at the end of the third quarter of 1981 and fell to 1.88 percent by the end of 2011. It is a mathematical impossibility for yields to fall a similar amount over the next 30 years.

In tumultuous times, U.S. government bonds are still considered the safest haven regardless of S&P’s credit-rating cut last August. If the various doomsday scenarios prove to be overly pessimistic, we think yields are much more likely to move higher (and bond prices lower).

Franklin D. Roosevelt famously said, “When you get to the end of your rope, tie a knot and hang on.” Investors who heeded that advice during the scary decline last August and September have been rewarded. Early 2012 has been calm, but remember that thought when the next market downdraft hits.•

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Kim is the chief operating officer and chief compliance officer for Kirr Marbach & Co. LLC, an investment adviser based in Columbus, Ind. He can be reached at (812) 376-9444 or mickey@kirrmar.com.

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