Stocks and other risk assets surged in the first quarter, continuing the strong run that began in the fourth quarter of last year. In each of the past two quarters, U.S. stocks gained about 12%, marking one of the strongest runs over the October-March span going back to the 1920s. Developed foreign stocks increased nearly 12% in the first quarter, emerging-markets stocks gained 14%, small-cap U.S. stocks were up 12%, and high-yield bonds rose 5%.

Treasury yields rose slightly in the first quarter, creating a headwind for investment-grade bonds, which are the core bond holdings in most balanced portfolios. As a result, many actively managed bond funds, which underperformed last year as Treasuries rallied, are once again adding value relative to the core bond index.

Coinciding with the recent stock market rally, and after an extremely turbulent 2011, stock market volatility has subsided (although I would note that in the first quarter of 2011 volatility was similarly quiescent prior to spiking to new highs in the next two quarters). The Chicago Board Options Exchange Volatility Index, or VIX, is a commonly used indicator of market volatility. Often referred to as the “fear index” it is a measure of investors’ expectations of S&P 500 volatility over the near term. The lower the VIX the less fear or risk-aversion there is in the market. As of March 23, 2012, the VIX stood at its lowest level since July 2007, and was well below its long-term average reading as well. When the VIX reaches extreme levels it is often a good contrary market indicator, particularly when volatility is very high. That is, very high levels of volatility (fear) suggest the market may be nearing a bottom and vice versa. The VIX hit its recent peak right at the October 2011 stock market low. Of course, the ultimate peaks and troughs in any index or indicator can only be known in hindsight.

What’s been driving this rally in global risk assets over the past several months?

There are always a multitude of factors that drive financial markets over the shorter term, but from a fundamental perspective the following are among the key positive developments in recent months.

» The receding fear of a European debt contagion/financial crisis, at least for the time being, due to a combination of the European Central Bank’s long-term refinancing operations, or LTRO, as well as other stimulative global central bank actions taken in late 2011 and early 2012.

In late December and again at the end of February, the ECB undertook the LTRO, whereby they offered essentially unlimited three-year loans to European banks at a 1% interest rate and with easier collateral requirements. In total, over one trillion Euros ($1.3 trillion) was borrowed by more than 800 financial institutions across Europe and the United Kingdom in the two LTROs.

The December LTRO slowed, if not fully stopped, the adverse feedback loop of forced deleveraging among European banks that was gaining momentum last winter. The LTRO also had the effect of supporting the peripheral European sovereign bond markets (e.g., Italy and Spain), where interest rates had been rising sharply. Because the banks were no longer being forced to sell assets, and other market participants understood that the cycle of forced deleveraging had been halted by the ECB, the price of government debt rose and yields fell, reducing these countries’ borrowing costs. This is critical, as a country’s borrowing costs (the rate it pays on its sovereign debt) can have a huge impact on its ability to continue to finance its deficits and ultimately reduce its overall debt/GDP ratio. Italian and Spanish 10-year government bonds that had been yielding around 7% in late November were yielding 5% or less in early March. (However, the yield on Spanish debt moved sharply higher in late March/early April on renewed concerns about the severity of the Spanish recession and questions about the government’s ability or willingness to meet previously agreed-upon deficit reduction targets.)

» The successful Greek debt restructuring(their second bailout) in March, in which Greece was able to write off 107 billion euro of debt to private lenders, was another positive for sentiment about the European debt situation.

» Positive U.S. economic data points,particularly with respect to employment. Nonfarm payroll employment rose by an average of 245,000/month during the three months from December through February, the largest gains since 2006; the unemployment rate has dropped from 9% in September to 8.3% in February, and; new claims for unemployment insurance recently hit a four-year low.

» The results of the Federal Reserve’s latest banking stress tests, in which 15 of the 19 institutions passed, gave the domestic market, and financial stocks in particular, another boost.

» A slowdown in the rate of inflation in China,which will allow the country’s rulers to take additional measures to support growth (e.g., by further easing monetary policy), boosting hopes they can engineer the hoped-for “soft landing” for the economy.

These are all positive developments, but they don’t signal an “all clear” on the macro front by any means, particularly because the analytical time horizon is not the next month or the next quarter, but the next five years. As with all things macro, there is always an “on the other hand”— a contrary data point or opposing interpretation to almost any piece of new data, hence the negatives…

» While the LTRO and Greek debt restructuring appear to have taken the disorderly default risk and European debt contagion risk off the table for now, it does nothing to solve the fundamental structural problems of the Eurozone.The LTRO provides the countries some additional time and space to try to implement necessary but extremely painful and difficult economic and political reforms. But, it is unclear whether reforms will work or will countries have to be forced to make change.

» The new Greek debt is currently trading at roughly 20 cents on the dollar, indicating the market is pricing in a high probability of yet another default/restructuring.Greece’s exit from the Eurozone remains a significant risk that could lead to contagion across the Eurozone.

» With respect to the recent positive U.S. economic numbers: New York Federal Reserve President William Dudley recently noted that roughly half the decline in the unemployment rate was due to a decline in the labor force participation rate.Dudley also noted that while GDP growth of 3% in the fourth quarter was “stronger,” most of that growth was due to inventory accumulation, while final sales-growth was weak, which bodes poorly for first quarter 2012 GDP growth. He also pointed out that the unusually mild winter weather this year likely caused a temporary boost to overall economic activity, pulling forward spending and hiring that would otherwise have happened in the spring.

» The looming U.S. “fiscal cliff”: In his recent congressional testimony, Fed Chairman Bernanke stated, “Under current law, on January 1, 2013, there’s going to be a massive fiscal cliff of large spending cuts and tax increases.” That is when the Bush-era tax cuts, the temporary payroll tax cut, and extended unemployment benefits are due to expire, and $1.2 trillion of automatic spending cuts begin to kick in—the result of last year’s Congressional Supercommittee’s failure to reach consensus. The impact would be a roughly 3.5% hit to GDP next year. It seems unlikely that it will actually play out that way without any modifications, but the risk of policy errors and political dysfunction, particularly in an election year, remains very high.

» There is also the risk of a military conflict with Iran that could cause a major spike in oil prices and consequently a severe negative economic shock and stock market decline. As many commentators have pointed out, prior to the 2008 financial crisis, the previous three global recessions (in the mid-70s, early 80s, and early 90s) were all preceded or precipitated by a sharp spike in oil prices.

My assessment…

There are always positive and negative data points and potential risks at every stage of an economic and market cycle. The one thing we can all be certain about is uncertainty! Investors would be well served to use a balanced approach to investing and focus on dividend strategies which throw off real cash. The old expression of “cash is king” certainly applies to today’s environment. Whether you are 25 or 65 more income gives you flexibility to reinvest for the future or use the cash to enjoy your retirement years. As always I’m available for comments or questions.

Best Regards, Wayne 

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