Weekly Market Portrait: US Markets in Week 51

As the year wound down, markets were largely tranquil during the final week of December 2012. However, a deeper examination reveals notable market dynamics that offer insights into portfolio management. This Week 51 snapshot provides valuable perspectives for investors.

Large Caps vs. Small Caps: A Tale of Two Markets

In Week 51, large cap stocks outperformed their small-cap counterparts. The S&P 500 returned an impressive 23.47% in 2012, while the Russell 2000 lagged behind with a return of 16.18%. Several factors contributed to this divergence:

Market capitalization: Large caps often exhibit stable earnings and dividends, making them attractive during volatile market conditions. Conversely, small caps offer growth potential but may be riskier due to their size and liquidity.

Sector exposure: Large caps tend to have greater exposure to defensive sectors like healthcare and consumer staples, which performed well in 2012. Small caps are often more cyclical, tied closely to economic growth.

Bonds: The Flattening Yield Curve

Bond markets also experienced trends during Week 51, with the yield curve flattening as long-term Treasury yields fell relative to shorter-term rates. This phenomenon is often associated with impending economic slowing or recession due to:

Monetary policy: When central banks engage in quantitative easing, they buy longer-dated bonds, driving down their yields and causing the yield curve to flatten.

Inflation expectations: A flat yield curve suggests investors expect low inflation ahead, which can signal an impending slowdown in economic growth.

Portfolio Implications: Navigating C, DIA, AGG

Considering these dynamics, let's evaluate how they might impact three popular ETFs:

- C (Vanguard Total Market ETF): Offering broad exposure to US markets with a large-cap tilt, C may benefit from continued outperformance of large caps over small caps. - DIA (Dow Jones Industrial Average Index Shares): Tracking the 30 largest US companies, DIA reflects large cap strength but with a more concentrated portfolio.

Risks and opportunities: - Risk: A rotation from large caps to small caps or a steepening yield curve could hurt C and DIA while benefiting AGG. - Opportunity: Large cap outperformance may continue, favoring C and DIA. Low bond yields make AGG attractive for income-oriented investors.

Scenario planning: - Conservative: Reduce exposure to long-term bonds like AGG and consider short-term bond funds or cash equivalents. - Moderate: Maintain a balanced portfolio with core holdings in C and DIA, supplemented by sector-specific ETFs. - Aggressive: Allocate more to small caps, considering funds that track indices like the Russell 2000.