From the February 2009 issue of Wealth Manager Web • Subscribe!

Where Do We Go From Here?

While the wild market ride that produced all the stomach-churning drops across the end of 2008 was surely launched by a lock-up in the credit markets, there is little doubt that weak GDP growth, rising unemployment, and sharp downward revisions in corporate earnings all helped push it to extremes. Even as consumer confidence hit an all-time low in October, the financial crisis devolved into a broader issue that engulfed the auto industry, ultimately propelling the markets to their worst year in a century. In the end, the broad equity indices were down 30% to 40%--completely wiping out the cumulative gains of the previous three years. And the fixed-income markets offered little refuge: While the broader bond indices were up 4% to 5%, corporate bonds as a sector were down sharply--regardless of credit rating.

But while looking backwards is interesting, and sometimes helpful, investors need to constantly look forward...and from that view ask two important questions: "Where do the markets go from here?" and "How do we take maximum advantage?"

We've noted before in this space that volatility breeds opportunity, and if nothing else, the last 18 months have been filled with it. This has produced opportunity in the non-Treasury fixed-income markets. With short- and intermediate-term Treasuries trading at negative real yields, there is little upside to these securities right now. Moreover, there's a fairly significant downside should inflation become a factor. Investment-grade corporate bonds, on the other hand, appear to offer significant upside. At year's end, the Barclays AA Credit Index was trading around a 6% yield to maturity--more than 4% higher than the Treasury Index. Even more interesting, the much broader A Credit Index was trading more than 5.5% over Treasuries.

Though reserved for the more adventurous investor, high-yield bonds offer even more potential. While that's not too much of a surprise, the extent of the opportunity is. At year's end, the Barclay's U.S. Intermediate High Yield Index was trading at a wildly discounted average price, producing a yield to maturity of more than 23%. Based on that pricing, the high-yield debt market is discounting default rates that would far exceed anything the market has ever seen. Worst case--assuming a recovery rate of 35 cents on the dollar (based on Moody's Investor Service data)--defaults would have to surpass 35% for investors with a more than four-year time horizon to lose money. Of course, spreads could certainly widen in the short term, and that elicits caution even among value investors.

Meanwhile, we're left with the very real question of when the equity market will begin its turnaround. Unfortunately, we know this can only be answered months, maybe even quarters, after the fact. Recall how the last bear market appeared to be over in late 2001 after the indices shot up more than 20% in the fourth quarter. The market actually stayed positive in the first quarter of 2002, only to tank some 30% over the next six months. But no matter what happens to the stock market--or when--a well diversified fixed-income portfolio will provide significant income today and could very well provide significant capital gains in the future.

J. Gibson Watson III is president and CEO of Prima Capital, a Denver-based firm that conducts objective, institutional-quality research and due diligence on SMAs, mutual funds, ETFs and alternatives.

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