Markets & Finance

The Potential for Absolute Returns in an Uncertain World


Several relatively uncorrelated asset classes appear to have become increasingly attractive amid the current turmoil

From Standard & Poor's Equity ResearchAfter declining sharply in 2008, global equities got off to a rough start in 2009 — the S&P 500 index declined 6.4%, and the MSCI EAFE index fell 7.9% year-to-date (through January 29). In addition, the S&P SmallCap index and the MSCI Emerging Market index compounded their sharp 2008 declines by falling 10.9% and 6.2%, respectively.

We believe broad-based global equity volatility is not surprising given deteriorating worldwide fundamentals and increasing global equity correlation. As a result, superior stock picking is more important than ever. In addition to Standard & Poor's Equity Research's STARS recommendations, we recommend investors also consider a broader array of asset classes in their search for positive absolute returns.

Some asset classes offer strong capital appreciation opportunities, while others merely represent an opportunity to improve yields on cash reserves. We believe an equal-weighted portfolio comprised of the four strategies outlined below has the potential to generate positive absolute returns during this difficult period. Alternatively, the volatility of traditional equity-only portfolios can be reduced through the inclusion of one or more of these less-correlated asset classes, in our view.

Investment-Grade Corporate Bonds

As a worsening global recession and significant "flight to quality" buying have depressed U.S. Treasury yields, many investors are buying investment-grade corporate bonds as a way to improve the yield on their cash reserves without adding too much risk. Bulls contend that the higher risk of investment-grade corporate bonds is largely discounted by their wide spread over comparable Treasury bonds. While advocates acknowledge that corporate defaults are likely to continue to rise as the economy deteriorates, they contend this risk is largely reflected in current depressed valuations.

The iShares iBoxx Investment Grade Corporate Bond ETF (LQD) pays dividends quarterly and recently yielded 5.5%. Its annual expense ratio is 0.15%.

S&P Dividend Aristocrats

While recent equity market turmoil has been broad, U.S. companies with a long history of increasing their dividend payouts have historically outperformed their peers. The S&P High Yield Dividend Aristocrats index, comprised of the 50 highest yielding constituents of the S&P 1500 Composite index that have increased dividends every year for at least 25 consecutive years, fell only 23% in 2008 versus a 36.7% drop for the S&P 1500 Composite index. (Of course, past performance is not indicative of future results.)

Many yield-oriented equity portfolios have been undone by an over-reliance on the financials sector, which is home to many companies with above-average yields. This strategy mitigates that problem in that reduced dividend payouts result in expulsion from the S&P High Yield Dividend Aristocrats index. In light of widespread financials sector dividend reductions, there are currently only four financials in the top 30 holdings of the S&P High Yield Dividend Aristocrats index, which together comprise 56% of its market cap.

The SPDR S&P Dividend ETF (SDY) tracks the S&P High Yield Dividend Aristocrats index. It pays dividends quarterly and recently yielded 6.1%. Its annual expense ratio is 0.35%.

U.S. Dollar

As the global credit crunch and de-leveraging have spread, we believe the U.S. dollar has benefited from aggressive "flight to quality" Treasury buying instead of riskier fixed-income securities. In addition, the dollar has benefited from a dramatic decline in overseas economies, which has forced foreign central banks to ease aggressively, undermining their currencies. The gains have been most notable against the euro, pound sterling, and Canadian dollar as the Eurozone, United Kingdom, and Canadian economies have deteriorated sharply, forcing their central banks to slash rates.

The European Central Bank lowered Europe’s short-term repo rate to 2% (rate current as of February 2), and S&P expects continued easing to combat mounting recessionary pressures. S&P Economics forecasts Eurozone GDP (gross domestic product) will decline 1.8% in 2009. In the United Kingdom, the Bank of England cut rates to 1.5% (rate current as of February 2) on a weakening economic outlook. S&P Economics forecasts a 2.7% contraction in U.K. gross domestic product (GDP) in 2009. In Canada, the Bank of Canada recently lowered short-term rates to 1% after falling U.S. exports and low commodity prices took a toll on growth. IHS Global Insight forecasts a 2009 Canadian GDP contraction of 1.5%.

With global de-leveraging far from over, by our analysis, we believe the global recession and credit crunch will be with us for a while. This should help maintain a "flight to quality" bid in Treasuries, which would offer further support to the U.S. dollar, as would continued international economic deterioration, which we think is likely.

The PowerShares DB U.S. Dollar Index Bullish ETF (UUP) uses futures contracts to track the U.S. Dollar index. It includes the euro (57.6%), Japanese yen (13.6%), British pound (11.9%), Canadian dollar (9.1%), Swedish krona (4.2%), and Swiss franc (3.6%).

The PowerShares DB U.S. Dollar Bullish rose 3.5% through January 29. Its annual expense ratio is 0.50%.

Commodities

The significant toll of the global recession on raw material demand has been exhaustively chronicled in the investment community, increasing the odds that it may now be largely discounted in depressed commodity prices. While further deterioration in the global economy could certainly drive prices even lower over the near term, we believe the long-term, risk-reward ratio of the commodity asset class is increasingly compelling. Our conviction is due in part to the much larger drop in raw material prices than equities in reaction to the global recession. We believe commodity traders have been quicker to price in a worst-case scenario than equity investors. Through January 29, the S&P GSCI Commodity index lost 66.8% from its July 2008 all-time high, while the S&P Global 1200 Index declined 49.4% from its October 2007 apex.

Oil has by far the largest weighting of any commodity in the S&P GSCI Commodity index. S&P analysts forecast West Texas Intermediate crude oil prices will average $51 a barrel in 2010, a premium to current levels, as demand eventually improves amid reduced supply. S&P metals and mining equity analyst Leo Larkin believes gold will rise in 2009, as low short-term interest rates reduce the opportunity cost of holding gold, while greater currency volatility increases the demand for bullion as a monetary reserve asset.

In addition, we believe that gold production will remain stagnant for the balance of the decade, as old mines become depleted and are not replaced to the extent needed to lift output. This, combined with rising demand, should lift the gold price, in our view.

The iShares S&P GSCI Commodity-Indexed ETF (GSG) tracks the S&P GSCI Commodity Total Return index, which is comprised of energy, industrial metal, precious metal, and agricultural raw materials. Its annual expense ratio is 0.75%.


Steve Ballmer, Power Forward
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