PrintOctober February 2, 2012

After a disappointing year in 2011, stocks got off to a good start in 2012. The S&P 500 Index closed the first month of the year with a 4.5% gain, its best January since 1997. Foreign stocks, which lagged the U.S. stock market significantly in 2011, bounced back as well with a 5.4% return in January, as measured by the MSCI EAFE Index.

Is this something sustainable, or did the switch just flip from the risk off position to risk on again? That is the million dollar question, the answer to which remains to be seen. However, aside from the positive returns in January, there were other pieces of data/news that suggest the mindset of investors is changing:

• The European situation continues to drag on, and in January S&P handed out downgrades to the sovereign credit ratings of France, Austria, Spain, Italy, and Portugal, yet investors shrugged off the news—a major development for a market that has been Euro-centric in its focus recently.
• On January 19, for the first time since July, volatility—as measured by the VIX—closed below 20, within its “normal” trading range historically.
• 2011 produced 35 trading days in which the S&P 500 moved by at least 2% with 32 of those days occurring between August and December. January 2012 had no such days.
• With volatility declining, we would expect correlations to decrease as well, and they are. For example, the tech sector (XLK) and the industrial sector (XLI) have an average 30-day rolling correlation of 0.73 since the start of 1999. The correlation peaked at 0.98 (maximum = 1) in mid-September and has since fallen to 0.83, still elevated but trending in the right direction.

 While correlations have not fallen far enough to find as many trends as we would like, we are seeing two obvious ones. The first is domestic over international investments. The second is income, as dividend-paying equities, REITs, and covered call strategies lead our momentum rankings. We have your portfolios positioned to take advantage of these two broad trends while we wait for more narrow ones to form.

Last month, we downgraded gold mining stocks to a sell. While gold miners remain undervalued to the price of gold, investors are not recognizing it. While value investors wait patiently (often for years), we must follow the momentum and move on to the next trend.

Sincerely,

Matthew P. King, CFA
Chief Investment Officer