2Q 2013 Commentary
by Richard Siegel, CFP®
“Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.” – John Templeton
In last quarter’s commentary, we wrote “A strong economy is positive for the U.S. dollar and the overall health of the country, but if the economy improves too much, the Fed is likely to take its foot off the gas pedal, reducing or eliminating the artificial stimulus program that has been partly responsible for driving up stock prices for the last few years.” This scenario is now playing out. Federal Reserve Chairman Ben Bernanke’s recent press conference suggests that the Federal Reserve will begin tapering its large scale asset purchases (“QE”) by year-end and conclude the program by mid-year 2014 assuming that the economic data warrants such action. The capital markets reacted with a tremendous spike in interest rates and a corresponding sell-off in stocks, bonds and gold.
ACWI = World Stock Index (50% U.S. / 50% foreign markets), AGG = U.S. Bond Market, GLD = Gold
A reduction of government stimulus should be viewed as a positive. If indeed the U.S. economy is strong enough to stand on its own two feet, then it should. Printing money in perpetuity is not a long term solution to a fragile economy, and is sure to result in an inflation problem. Regarding asset prices, a pullback in the stock market was long overdue and should be viewed as normal. In a perfect world a two steps forward, one step back pattern would be ideal. Typically speaking, fixed income assets serve to hedge against a stock market correction, propping up portfolios from significant losses. Recently all assets have been highly correlated and have declined together. We feel this is a temporary phenomenon and will be short-lived. The chart below shows how four completely different indices (U.S. stocks – SPY, world stocks – ACWI, municipal bonds – TFI and corporate bonds – LQD) had the exact same reaction to the recent economic policy headlines.
Even after the June market drop, U.S. stocks eked out a positive return for 2Q and outperformed both foreign developed and emerging markets. We continue to invest globally based on the long term benefits of a diversified portfolio. The following series of performance charts perfectly illustrates that over 10 years, all three benchmarks (U.S. Stocks, Europe/Asian Developed Markets, and the All Country World Index) have delivered similar returns.
Same with a one year chart…
Here is the opportunity: Over the last three years, the foreign markets have significantly lagged the U.S. Stock market. These trends are cyclical and can be based on currency fluctuations as well as geo-politics. The Fed began its stimulus program in 2009 to bolster the economy and banking system, while the Eurozone was much slower to act. Additionally, there have been improvements to economic stability in the region. Based on regression to the mean as well as valuation metrics, foreign markets have become more attractive and may present a better opportunity than U.S. stocks over the near term.
Fixed Income Overview
Over the past year, we have been stressing the idea of bond yields moving higher and bond prices moving lower based on economic growth, inflation, a reduction of government stimulus, or all of the above. Based on this thesis, we’ve made conscious decisions to reduce and even completely avoid areas of the fixed income markets that present the greatest risk of loss during periods of rising interest rates; specifically the long end of the yield curve (10+ years of duration). To this end, we have been comfortable focusing more on capital preservation than maximizing yield. Although we have positioned portfolios to avoid significant impairment of capital, we are not completely immune to short term price volatility. Currently our portfolios have an average duration of approximately 4 years.
AGG = U.S Aggregate Bond Market (duration of 5.3 years), TLT = 20+ year Treasury Bond Index (duration of 16.9 years)
The second quarter ended with rates on the 10-year Treasury benchmark at 2.49%, much higher than just two months earlier. Although rates will not move in a straight line, we expect they will continue to trend higher over the intermediate to long term. This should be seen as positive because it means that the yields are normalizing and investors will receive higher dividends. We view the recent spike in rates as an overreaction to “Fed Speak,” and expect that interest rate volatility will settle down before grinding higher.
It is worthwhile to note that the last two instances Treasury rates experienced significant moves higher and bonds lost value was 1994 and 1999. In both cases, the return on the U.S. aggregate bond index delivered strong returns the following year.