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Craig Allen: 2012’s Highly Volatile Second Quarter Over But Concerns Remain

Chronically high unemployment, tax rate risks, elections and the global economy all add to climate of uncertainty

With the second quarter of 2012 behind us, it’s time to look to the future, preferably with a little more optimism. But questions and concerns remain that could overshadow the financial markets and the economy, at least in the short-term.

Equity markets experienced a significant correction at the end of May/early June, with stocks falling about 11 percent from the peak to the low. The Standard & Poor’s 500 reached its recent high of 1,422 on the first trading day of the quarter, April 4, before beginning a slide that would culminate in a severe sell-off between May 30 and June 1. During this three-session period, the S&P 500 dropped to 1,278 from 1,332, or by 4 percent. Selling continued on Monday, June 4, with the S&P 500 falling to an intraday low of 1,266 before rebounding to close at 1,278 (the previous session’s closing level).

From the beginning of the quarter (1,422) to the low point of the correction, the S&P 500 lost 156 points, or about 11 percent.

As those of you who read my column regularly or listen to me on AM 1290 already know, I had been expecting this correction for several weeks and had sold the majority of positions held for my clients, raising approximately 90 percent in cash prior to the correct. I re-entered the market on May 31 and continued buying on June 1, reinvesting approximately 70 percent of my cash positions for clients.

Stocks rallied sharply from the intraday low of 1,266 set on June 4, and although we experienced a lot of volatility during the remainder of the second quarter, closed at the high point of the rally, with the S&P 500 ending the quarter at 1,362. (The rebound from the intraday low of 1,266 to the quarter-ending value of 1,362 represents a 7.6 percent gain.)

The MPAM Model Growth Portfolio (Montecito Private Asset Management) gained 3.63 percent during the second quarter, compared to the S&P 500, which lost 3.3 percent. As I discuss with my clients, avoiding losses when the market is declining is much more important than capturing gains when the market is rallying. The ideal situation is to make a positive return when the market is declining, which is what I was able to achieve for my clients during the second quarter.

Although I am pleased with my performance, many questions and concerns remain regarding the health of the markets and the global economy. The debt crisis in Europe continues to loom large. There can be no doubt that other countries such as Italy and Spain will need substantial bailouts in the near term. Greece is certainly not out of the woods, and will run out of money (again) later this month, requiring another injection of external capital. Cyprus also just asked for a bailout, and although this is a tiny country, it underscores the risks associated with the broader global economic weakness and huge debt loads of not just governments, but corporations and individuals across the world.

The U.S. elections are coming soon, as well, and the Bush tax cuts are set to expire at the end of this calendar year. Congress will not take up any debate on the possibility of extending these tax cuts, until after the election (if ever). This means we will not know whether the tax rates will be extended until after they officially expire. This will no doubt cause significant uncertainty regarding the tax status of incomes, capital gains, dividends, inheritance, and much more. The implication of the possible increases in taxes on various income and assets will likely cause more volatility as investors rebalance portfolios to mitigate the risk of substantially higher taxes.

Unemployment is also a major concern. The latest Commerce Department report showed only 80,000 jobs added in June. We need to add at least 500,000 per month to have a healthy economy and to drive down the unemployment rate at a reasonable pace. A healthy economy has an unemployment rate around 4 percent. We are currently at 8.2 percent, and while that rate did not change from the previous month, the reality is that this number grossly underestimates the true percentage of those able to work but who do not have a job. Those unemployed individuals who have exhausted their unemployment benefits are simply no longer counted in the calculation of the unemployment rate. The conclusion must be that they all found jobs. Sure, they did! The reality is that very few actually find jobs; the overwhelming majority are still unemployed, or become underemployed, taking jobs for low pay that are far beneath their earning ability to make ends meet.

Employment will certainly be a major topic of debate during the election campaign, with both major parties blaming the other for our current lack of job growth. The government has been printing money and selling short-term securities to force down long-term interest rates in an attempt to spur economic growth. So far, the results have been less than satisfactory, while these operations have swelled our national debt to above $15 trillion (about the same amount of our entire annual gross-domestic product). The pressure is on to conduct a third round of quantitative easing (QE), although I do not believe this would be any more effective than the last two rounds have been.

I continue to hold a significant amount of cash in client portfolios. Should we rally above 1,400 on the S&P 500 again, I will most likely trim positions, raising more cash. If stocks decline toward the 1,200 level, I will be a more aggressive buyer. In between 1,200 and 1,400, I am staying on the sidelines, waiting to see what direction financial markets and the economy will take next. One thing is certain, it will not be boring!

Craig Allen, CFA, CFP, CIMA, is president of Montecito Private Asset Management LLC and founder of Dump Your Debt. He has been managing assets for foundations, corporations and high-net worth individuals for more than 20 years and is a Chartered Financial Analyst (CFA charter holder), a Certified Financial Planner (CFP) and holds the Certified Investment Management Analyst (CIMA) certification. He blogs at Finance With Craig Allen and can be contacted at .(JavaScript must be enabled to view this email address) or 805.898.1400. Click here for previous Craig Allen columns. Follow Craig on Twitter: @MPAMCraig.

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