Waddell & Reed Advisors Asset Strategy Fund – October 2011
EXTREME VOLATILITY was the market norm in August and September, with the major indexes frequently falling or rising three to four percent on a given day. Much of the volatility was driven by anxiety surrounding Europe’s debt crisis, which has also caused record correlations among stocks. Asset Strategy Fund co-managers Mike Avery and Ryan Caldwell and assistant manager Jonas Krumplys share why they think such an environment favors good stock selection.
Despite the nearly unprecedented volatility that has pummeled the markets in recent weeks, economic data does not yet show the weakness reflected in equity prices. We’ve seen some slowing in regional manufacturing and the employment picture remains troubled, but executives and business owners continue to report that while they are concerned about the future, generally they have not seen a significant decrease in activity.
A mixed global economic picture
As we look around the globe, we see a mixed economic picture. China’s economy appears healthy and we anticipate it will produce attractive growth, although it has slowed a bit from its peak. The big concern there has been inflation, but it appears to us that particular fear has receded a bit as energy and commodity prices have moved lower.
Brazil’s central bank recently cut interest rates after a series of rate hikes, possibly ending its tightening cycle, and the Turkish Central Bank cut rates as well. We may be seeing a move toward easier monetary policy in emerging markets, which at some point will be very positive for those economies. Economic growth in those regions has continued to be very strong, and even though it has slowed a bit recently, we believe the absolute levels remain very good.
Euro zone plight continues
The big story continues to be Europe, where the debt crisis has intensified and driven much of the recent volatility in global markets. The crisis stems from a downward economic spiral that has hammered Europe’s weaker economies, starting with Greece, which has a debt load that exceeds 140 percent of gross domestic product (GDP). The Greek government has cut spending and raised taxes to try to entice stronger economies, such as France and Germany, to continue bailing it out. Unfortunately, it looks like those budget cuts have sent Greece’s economy into even deeper distress. We anticipate this crisis will worsen before it is resolved, and we think it is likely that Greece will eventually default. At times the confidence crisis has been poised to spread to Italy, Europe’s third-largest economy, requiring intervention on the part of the European Central Bank (ECB). The country’s latest move has been to raise taxes, a tactic we think will create an even bigger drag on its economy.
European leaders have been trying to create a financial plan to contain the recurring crisis. The European central bank ECB has purchased some Greek and Italian bonds, but we feel its efforts have done little to calm investor anxiety or create the confidence needed to effectively turn this situation around. The problem remains with Europe’s banking system. It is under-reserved and inadequately capitalized to manage the fallout that would result from a sovereign default. We believe the endgame in Europe will be a big recapitalization, and we expect to continue to see extreme volatility in the euro zone until recapitalization becomes a reality. The vulnerability of the European banking system is the key to this crisis and providing investors with clarity and certainty that the banking system is strong and well capitalized will be the keys to resolving it.
Correlations near all-time high
As these events play out on the global front, we have taken a different approach to our thinking about Fund allocation. Sovereign debt has been a good performer in the last four to five weeks, but we think our advantage is to be lower in the capital structure, given our three-year outlook. So, high-yield securities and equities are more attractive to us now than sovereign debt.
We’re now seeing a very high level of correlation among stocks. Correlation is a statistical measure of how two securities move in relation to each other. A high correlation indicates securities are moving in the same direction. A low correlation indicates securities that are not performing similarly. In the S&P 500 on a one-month basis, correlation has risen to over 80 percent compared with an average over the past 20 years of 28 percent. There are three fundamental mathematical drivers of correlation: market volatility, stock-specific data in the markets and stock-specific volatility, which is idiosyncratic risk. This has been a big focus for us during the past 12 months. Correlations at these levels mean the market is not discriminating among companies or sectors. We do not think this is justified and correlations will eventually recede.
In a typical market decline, stock-specific volatility will decrease because the correlation of the fundamentals driving earnings typically increases, and broad market volatility increases. There’s little differentiation among stocks in a typical bear-market, because companies may be cutting revenue forecasts or earnings, correcting inventories, reducing head count or undertaking any number of other actions.
However, during this correction, we have not seen the correlation among company-specific events increase. The correlation of the earnings-per-share revisions to stock prices usually is around 30 percent; right now, the correlation is at 1 percent. We do not expect this to last. While security prices have been moving together, company-specific events like earnings revisions have actually shown more dispersion than typical. This leads us to believe that in the future, if correlation among stock prices decreases, good stock selection will be rewarded as the market begins to price based on company fundamentals.
Emphasis on selection
We believe this environment means it’s time to be more active. We want to position the Fund in ways that will enable it to exploit what we think are better trends, better companies and better sectors. When the market isn’t differentiating in return on a stock-to-stock basis, and there’s no correlation between the fundamentals, there are opportunities in discerning which companies have good growth profiles, strong balance sheets and high cash flow yields. That means tremendous opportunities for good stock pickers. Valuations are indiscriminate, but the fundamentals are quite diverse, and we think certain stocks are very attractive right now.
We do not believe these dislocations can persist. When the short-term correlations eventually dissipate, stock returns are going to become linked to their fundamentals, which will cause correlations to decline. When that happens, we believe fundamentally good companies will be winning the day. That’s why we are concentrating heavily in our high-conviction positions. We’re doing our homework, performing fundamental research on each potential holding. That work has resulted in the Fund’s current net-equity position, with fewer stocks in the portfolio and bigger weights. As a result, the risk in the Fund currently has more to do with individual stocks and their trajectories than the risk in the market.
A look ahead
We believe market volatility will remain high. Additionally, the time period in which we operate has compressed markedly in the last three years. Bad gets bad really fast and good gets good really fast. We don’t anticipate that changing until systemic risk declines. In the meantime, one item on our watch list is the potential for sentiment data to create an economic reality. Markets don’t predict anything, but they do influence the outcome. Sentiment is terrible, but the actual economic data recently is not terrible, in our opinion. When we look at behavior around sentiment, which is important, we are nervous on two fronts. We’re concerned about how corporate Chief Financial Officers behave because we are starting the underpinnings of a capital expenditure cycle. CFOs say their businesses are chugging along, but they want to protect margins because they’re not confident. This is of particular concern in Europe, where we think the economic outcome will be more of a contraction because policy makers made a massive policy mistake, rates are too high, the yield curves are too flat, economic activity is slowing domestically and there is genuine, widespread fear of recession.
The other area of concern for us relates to high-end consumers. This is critical; high-end consumption has driven the rebound in retails sales. Look at companies that produce high-end, luxury consumer goods which have done very well through the downturn. Sales of luxury cars are off the charts, and not just in China, but in Europe and the U.S. as well. The high-end consumer has been the savior of the global equity markets. If these consumers decide to rein in their spending, things could get worse quickly.
With these concerns in mind, we will continue to carefully monitor risk and think about protecting shareholder capital. In analyzing the next 12 to 36 months, we think the key factors will be more about owning the right stocks and the right sectors at the right price within a very volatile market environment.
Past performance is not a guarantee of future results. The opinions expressed are those of the Fund’s managers and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through October 7, 2011, and are subject to change due to market conditions or other factors. The S&P 500 is an unmanaged index that tracks the stocks of 500 primarily large-cap U.S. companies.
Risk factors: The Fund allocates from 0–100 percent of its assets primarily among stocks, bonds, and short-term instruments, across domestic and foreign securities. • International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. • With regards to fixed-income securities in which the fund may invest, these are subject to interest rate risk and, as such, the net asset value of the fund may fall as interest rates rise. • Because the Fund may concentrate its investments, the Fund may experience greater volatility than an investment with greater diversification. • The Fund may use short-selling or derivatives to hedge various instruments, for risk management purposes or to increase investment income or gain in the Fund. These techniques involve additional risk. • Investing in physical commodities, such as gold, exposes the Fund to other risk considerations such as potentially severe price fluctuations over short periods of time. These and other risks are more fully described in the Fund’s prospectus. • Holdings information is not intended to represent any past or future investment recommendations. Holdings and allocations can and do change frequently.
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