Prima Capital’s Nathan Behan: Fourth-quarter commentary

Nathan Behan, a senior investment analyst at Prima Capital Holdings, outlines some key recent and long-term trends in the markets in an economic report and analysis on the first quarter.

DOMESTIC EQUITY

October started the fourth quarter off with a bang, following on the heels of the sharp rally in September. November was mixed as the market’s momentum in the large-cap arena slowed in the aftermath of the elections and some slightly weaker economic data. The small-cap market slowed not at all, churning out a healthy 3.5% return for the Russell 2000 Index.

But the candle was really lit in the final month of 2010, as optimism around the holiday retail season and marginally improved economic news sparked a sharp rally. December accounted for more than half the quarter’s return for the large-cap indexes and slightly less than half for the mid- and small-cap indexes. Continuing the trend we have seen for most of the year, the small-cap indexes sharply outperformed large caps, and growth outperformed value from a style standpoint. The Russell 2000 Growth Index was up 17.1% for the quarter and 29.1% for the year, leading the domestic indexes, while the “laggard” was the Russell 1000 Value Index, up 10.5% in the final quarter and 15.5% for the year.

The dramatic recovery of the mid- and small-cap indexes over the past two years has pushed the longer-term trailing performance back into positive territory, though certainly well below the level (particularly on a real return basis) that would seem reasonable for the level of risk being assumed. The Russell 2000 Index has a five-year trailing performance of 4.5% annually and a 10-year trailing performance of 6.3% annually. Much worse are the numbers for the large-cap indexes, as the Russell 1000 is up just 2.6% on average annually over the past five years and 1.8% over the past 10.

One of the major issues that continues to worry the asset managers with whom we have spoken this year is the growing gap in valuation levels between the highest-quality companies and the lowest-quality companies (typically defined by the Standard & Poor’s ratings). The gap continued to widen in the fourth quarter, and although it is expected that lower-rated companies carry lower multiples to compensate for the inherent risk, these multiples have moved out past the historic norms (pushed by the “risk on” trade for most of the year). Meanwhile, multiples for the highest-rated companies continue to be below their historical averages. This is a condition that was seen in the dot-com era of 1999 and early 2000, and to a lesser degree during the run-up in 2008. If these lower-quality companies are being priced to perfection, 2011 earnings comparisons could pave a rocky road.

INTERNATIONAL MARKETS

The international indexes were positive during the final quarter of the year, though the broader indicators underperformed the U.S. market. In dollar terms, the Russell Developed ex-U.S. Index was up 7.4% during the quarter, while the Emerging Markets Index was up 9.8%. The fourth-quarter performance left most of the regional indexes slightly behind the domestic indexes for the year as well. Among the developed countries, Canada and Japan were the leaders for the quarter and, unsurprisingly, Greece and Spain posted substantial losses. Among the emerging-markets countries, Taiwan, Peru and Mexico had the largest gains (all more than 16.5% in dollar terms) for the quarter, while Hungary and Colombia finished with significant losses.

The currency impact was decidedly mixed in the quarter as the dollar weakened significantly against most of the Asian currencies, especially in Taiwan, but strengthened slightly against the euro and many northern European currencies.

FIXED INCOME

The domestic fixed-income markets closed 2010 on a down note, as the yield curve shifted dramatically upward in November and December. Marginally positive economic data, higher issuance and lower demand combined to push prices down and yields higher. In a reversal of the previous two quarters, the yield curve steepened dramatically, with the two- to 10-year spread widening 58 basis points. The losses in the bond markets were especially steep at the long end of the curve, where yields rose 65 basis points on the 30-year Treasury, and the Barclays Treasury 20+ Year Index fell 9.3%, cutting the year’s return in half.

Treasuries fared the worst in the quarter (-2.6%), though the returns in the industrial (-2.1%) and utility (-2.5%) sectors of the corporate market were down nearly as much. Bucking the trend was the MBS Index, which actually had a gain for the quarter, due to a large positive return in October and smaller losses in November and December.

Despite the losses in the final quarter, returns for the investment-grade market were well ahead of expectations for the calendar year, particularly given the average forecast last January for higher rates in the first half of the year. Slower-than-expected economic growth in the first half of the year, combined with the European sovereign-debt crisis in May (and the subsequent flight to Treasuries), provided a good cushion and ultimately mid- to high-single-digit returns for the asset class. All of that leaves the asset class in about the same position as it was 12 months ago: very low yields, a high probability of rising rates in the coming year and very low expectations for total return.

The non-investment-grade market enjoyed another strong quarter with the Barclays High Yield index up 3.2% for the quarter and 15.1% for the year. The average option-adjusted spread on the index fell nearly 1% over the course of the quarter. The third and fourth quarters saw increased investor appetite within the non-investment-grade sector, as reasonable valuations and faint signs of economic recovery appeared to highlight positive future prospects for these issues.

MUNICIPAL BONDS

The muni market was struck harder in the fourth quarter than the taxable market. The Barclays Capital Municipal Bond Index was down 1.9% in December and 4.2% for the quarter. The dramatic results were due to a combination of market-oriented factors and a few technical issues. The muni market was affected by the same issues affecting the taxable market — the marginally better economic data generically pushing interest rates higher.

However, the major impact to the market was a dramatic shift in the supply/demand fundamentals, particularly in November and December. California’s budget was settled later than usual, and the state came to market with several very large new issues in November. At the same time, a number of other states came to market with new issuance in an attempt to tap the Build America Bond market before the program expired at the end of the year.

Both these factors collided with dramatically lower retail interest in the asset class, as investors moved strongly into the equity markets after the third-quarter rebound and continued strong results in October. Among the investment-grade issues, longer maturities and lower credit qualities suffered greater losses. The Barclays Capital High Yield Municipal Bond Index was down 3.9% for the quarter.