20120510 KCM Commentary

Kenjol Capital Management • 7000 N. Mopac Expressway, 2nd Floor • Austin, Texas 78731 866.453.6565 • 512.506.9395 • [email protected]

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May 10, 2012 Greetings, As the calendar turns to the month of May, school children become restless in anticipation of summer. In a similar manner, markets have returned to their wacky, nerve-rattling ways, with headlines in Europe and economic concerns domestically again resurfacing. Below, we summarize the events unfolding over the last few weeks which have contributed to the negative change in the investment market outlook. Sell in May & Go Away As discussed in Stock Trader’s Almanac, the “sell in May, go away” phenomenon has returned in 2012. More than ever, the media seems to be picking up on this seasonal trend and is reporting on it. Conversely, investment houses and mutual fund companies are publishing whitepapers and hosting webinars enumerating reasons as to why investors should ignore the phenomenon this year. In our opinion, this seems self-serving as they are encouraging you not to sell their product. Volatility returned during the summer months of both 2010 and 2011, and markets weakened and gave back much of their year-to-date gains. In 2010, we dealt with the “flash crash” and a tumultuous summer. The market decline was only saved in late August with the Fed announcement of their next round of quantitative easing which resulted in the “risk-on” trade with risky assets taking off. In 2011, markets sold off immediately with the turn of the calendar to May, and investors were in for a “stomach in the mouth” rollercoaster ride culminating with the Washington budget standoff and news media’s “7-6-5-4...” countdown of the U.S. Treasury default. Once we passed that hurdle with a budget agreement, market sentiment was whacked by the news of S&P’s downgrade of the U.S. debt from AAA rating. While struggling to move higher during the summer months, in both years, the market found its legs by the fall and put in most of the yearly gains during the last months of the calendar year. Essentially, an investor could have sat on the sidelines until the last part of the year and gotten all the market gains as measured by the S&P 500 for 2010 and 2011. As of today, 2012 is looking like “déjà vu”. We are mindful of the “Best Six Months” / “Worst Six Months” phenomenon, and have reduced risk in our portfolios to seek safer grounds for the unfavorable time period we are currently in. One investment we like to use in this unfavorable period is the Doubleline Total Return fund which is managed by one of the best bond managers in the business, Jeffery Gundlach. We continue to believe that investors will want to be paid, and as a result, we also like high-yield bonds, preferred securities, and real-estate income investments. A Review of the Charts In the following charts, we will take a look at several of the major equity indexes. Markets began moving sideways (consolidating) in mid-March, before beginning their recent mild declines. Because Apple is not a component of the Dow Jones Industrial Average, the Dow held up better than both the S&P 500 and the Nasdaq as Apple, which rose nearly 50% in Q1 2012, began pulling back. Apple has simply become so large that it is difficult for markets to move higher while Apple declines in value. Currently, markets are testing their 100-day moving averages. As of today, the Dow, S&P 500, and Nasdaq all remain above these key technical levels. The same cannot be said for international markets, where the EAFE index (developed international markets) is getting smashed on the European woes. Investors are running away from Europe with the crisis spreading to Spain & Italy, and a declining Euro further magnifies the decline in U.S. dollar terms.


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Dow Jones Industrial Average:

S&P 500:


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NASDAQ 100:

MSCI EAFE (International):


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The coming days and weeks will tell us whether U.S. markets will follow European markets lower. As for now, markets have sold off on any bad news in May while not being able to breakout higher on signs of optimism. The concern is the herd mentality where selling begets selling which begets more selling. With that in mind, we wanted to review this chart from our friends at J.P. Morgan which shows calendar year returns for the S&P 500 by year (grey bar) along with the corresponding intra-year decline as represented by the purple dot below it. It is interesting to see that from the period of 1983 – 1996, there were only three years (1984, 1987, and 1990) when the decline was double digits. Stocks rewarded investors for the risk of the downturns. Starting in 1997, the intra-year declines became more fierce for the equity investor as the stock bubble began to pop. For the 14 year period from 1983 – 1996, the average intra-year decline was a -10.2%. For the 15 year period 1997 – 2011, the average intra-year decline has almost doubled to -18.3%. Again, the equity investor has gotten less return and bigger swoons with a stunning -47% drawdown in 2008. Much of this underperformance has been due to an expensive market by the end of the 1990’s, and a reversion to normal priced markets with today’s market.

Accordingly, the challenge for investors and investment managers is how to appropriately navigate the doubling in intra-year declines and volatility. How do we control risk? Repositioning to safer bond investments during part of the year is one way but not a comprehensive solution. Corporate Earnings, GDP Growth, Employment, & QE3? During April, the majority of corporations reported earnings for the latest quarter. While earnings reports were good and in many cases better than expected, markets were unable to push higher as reflected in the previous charts given two primary factors looming over the market. Notably, the European situation has returned to the front-page headlines with concerns again arising in Greece, Spain, and Italy.


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In addition, softer economic news including the latest revision down to Q1 2012 GDP to 2.2% from a previously announced 3.0% has reignited economic concerns domestically. Regional economic reports such as the Chicago Purchasing Managers Index (PMI) fell further than expected. However, this negative data was followed by the national ISM manufacturing report which significantly surpassed expectations and renewed investors’ hopes that the U.S. economy was holding up despite the European slowdown. More concerning is the employment numbers which have disappointed in recent months. Both ADP and government reported numbers came in below expectations and gave rise to the fear of a double-dip recession as is currently being experienced in European countries on the back of their austerity measures. As we have said for the last two years, while there is a chance of a double-dip recession, the probability is very low at this point. In our opinion, the economy is just muddling along, but a slowdown from these low growth levels does not appear imminent. As such, it will remain difficult for the jobs picture to significantly improve in the current environment. With the less than spectacular economic data, the Fed will continue its mandate to keep interest rates low and do everything possible to keep mortgage rates low as well. Again, if you have not considered a refinance of your existing mortgage, now is the time to do so with rates again near historic lows. Notable bond managers such a Bill Gross, Jeffery Gundlach, and Dan Fuss whose firms collectively oversee about $1.5 trillion in assets now expect the Federal Reserve to conduct a third round of bond purchases as signs of strength in the U.S. economy fade and the European sovereign-debt crisis continues. Why is this important for the markets? At a time when Roger Clemens, “The Rocket”, is on trial for perjury for his statements about performance enhancing drugs, the financial markets are looking for the next clues about the prospects of the Fed’s “performance enhancing” stimulus in the form of QE3 (quantitative easing). The chart on the following page reflects the performance of the S&P 500 with each round of Fed “rocket fuel”. Equity markets clearly traded higher during QE1 and QE2. Once each round of quantitative easing came to an end, markets flopped until the next dose of stimulus was announced. Notably, markets jumped in late August of 2010 on the announcement of another round of stimulus even before the program began. As each program ends, the market anticipates the conclusion and investors start to reduce risk and equity exposure. We are again coming to a close of Fed action, the end Operation Twist where the Fed has been buying long-dated bonds to drive down interest rates and the related yield curve. While this is a boon to those refinancing both at the consumer and corporate level, it decimates the income-oriented investments the retired generation relies on. While speculation of QE3 continues, we will probably not hear anything about action until the June Fed meeting. If nothing is proposed, markets may well selloff in disappointment. The question is does the U.S. have a liquidity problem or a confidence problem? We argue the latter, especially considering the fiscal cliff and pending tax rate changes looming in 2013.

European Mess The best supporting actress award for a dysfunctional market goes to the European debt crisis. While the market ignored Europe during the first quarter, the issue came back to investor’s minds in March with the Greek debt swap vote. Only two months later, investors now holding new Greek debt must question whether they will be repaid in Euros or in devalued Greek currency with the return to the Greek drachma. There are many camps on what should be done to fix the problem and whether it can be fixed. We are of the opinion that you cannot cut your way to prosperity. Germany is in the austerity camp, but the people in countries suffering through austerity and recession are changing their elected officials. Any business owner will tell you that you must increase revenues and decrease expenses.


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Elections this past weekend shifted the political landscape in Europe leaders again as the populace tries to deal with the debt crisis and austerity measures. Last Sunday, socialist candidate Francois Hollande won the French presidential election over incumbent Nicolas Sarkozy. This raises the level of risk in Europe specifically between France and Germany. Holland has been very critical of the European Union’s response to the debt crisis, has questioned the role of the European Central Bank (ECB), and voiced his desire to renegotiate France’s support for the sovereign rescue funds. Now, the market believes under his leadership we will have more political fighting among the European leaders on how best to solve the debt crisis amongst the Eurozone member nations. All in all, member nations have been working together in good faith to keep the EU together. If Hollande tries to renegotiate many of the pacts France agreed to under Sarkosy’s leadership, it could undermine many of the accords already established and amplify the tension between policymakers, ECB, and political relations among many of the other EU members. A possible World War III? And what do investors hate? Uncertainty! This is essentially what we now have with France under new leadership.

With Greece a lost cause, investors are keeping their eyes on Portugal as well as the larger Spain and Italy. In the chart below, notice that Portugal’s rates today are at the same place Greece was a year ago and we know how that turned out. The question will be whether Portugal can roll their debt or whether investors will shun that debt just like they did on Greek debt last summer. The risk for the markets is that the amount of debt becomes larger and harder to roll without multi-central bank intervention. Of greater concern is the yield of Spain and Italy’s 10-year bonds. Spanish yields remains right at the 6% level (6.08% close yesterday) while Italian yields closed slightly lower yesterday at 5.60%. The belief for investors is that as long as Spain and Italy remain below 6% and contained, those countries may have enough time to implement the structural changes needed to place both countries on sound footing. This proposition is very much in jeopardy.


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Looking Ahead We mentioned in March that the summer would be choppier. We really only have two choices with the environment handed to us. The first is to tie ourselves to the mast and sail through these choppy waters knowing that a better and smoother day will come (in the fall or with announcement of QE3?). The second option is to reduce our equity exposure and increase bond holdings. We have chosen the latter. While that doesn’t lend itself to big gains, it is more about preservation until a more favorable environment unfolds. Again, we do expect markets to push higher as we get into the fall. We could see dramatic moves pending the presidential election – at least for now we know who the two candidates will be for the fall election. It is sure to be an ugly campaign and presidential election. Thank you again for your business and continued support. Please call or email us if you would like to discuss your personal situation further. Regards,

Kenny Landgraf & David Levy

Economy & Finance

20120510 KCM Commentary