First Quarter 2013 Markets Review (written April 2013)

This month’s post looks at the following topics:

  • First Quarter Markets Review
  • Does this Mean Rebalancing into Bonds (?!?!)
  • Have You Seen the Latest From Washington? What it could mean for you

First Quarter Markets Review
Unless you were a bond, commodities or gold investor, it was a great quarter. March itself was an excellent month, capping a quarter that for the US markets were one of the best since 1926. US stocks rose to above 2007 levels, while non-US stocks remain well below those levels; developed markets outside the US remained relatively weak, and emerging markets were also weak in absolute terms.

Q1 2013 Market Results
Market Index Q1 2013 Year Ending 3-30-2013
Stocks
Large Cap S&P 500 Index 10.61% 13.96%
Midcap S&P Midcap 13.45 17.83
Small Cap S&P Small Cap 11.81 16.14
Non-US Developed Mkts. MSCI EAFE 5.13 11.25
Emerging Markets MSCI Emerging Mkts. -1.62 1.96
US Bonds Barclays US Aggregate -0.12 3.77
Gold Dow Jones-UBS Gold Sub index Total Return -5.01 -5.26
Commodities Dow Jones-UBS Commodity Index TR -1.13 -3.03

Sources: AJO Partners, Factset, Dow Jones Indexes

Factors contributing to the stock market rise included:

  • Extremely low yields available on bonds, which drove some investors into stocks for income.
  • Corporate earnings which materialized better than expectations held by Wall Street analysts.
  • Economic news that was not robust, but which was better than expected.
  • Concern from many about the markets and the direction of the economy. From a contrarian point of view, this makes the market more attractive. (Contrarians prefer that optimism not be rampant to maintain a positive view on a market.)
  • Japan’s adoption of a quantitative easing program of its own. Their goal is to drive out the deflation that has plagued their economy for 15 years. One of the program’s key goals (there are several) is to double the Japanese monetary base in two years and achieve 2% inflation in about 2 years. This massive monetary stimulus is causing money to flow out of Japanese bonds and into all sorts of other asset classes, including the US markets. One commentator called it “the Bank of Japan tentacles reaching US markets.” The impact of the program so far, in addition to driving money flows to other markets, has been a big surge in Japanese stocks, and a large decline in the value of the yen.

The BOJ action meant that the market ignored the potential fallout from Cyprus banking issues. In previous years, European banking problems have shaken global markets badly, but not last quarter.

Does This Mean Rebalancing into Bonds (?!?!?!)

With stocks having had such a strong run this quarter (and looking farther back, ever since 2009), if you haven’t reviewed your portfolio’s allocations across different asset classes, it is time to do so. You may find your portfolio is over allocated to stocks (unless you have avoided them since 2008, as many have).

If that is the case, then you may find that you are under allocated to bonds. Many ask about whether it is even worthwhile purchasing bonds at today’s low rates. It is admittedly a difficult time to think about making new purchases, but we have to look at the role they play in a portfolio. Normally we look to them as income instruments, and it is difficult to do so now. But the other role they play is as portfolio stabilizers. No matter how poorly bonds may do, their worst historical returns have never been as volatile as stocks.

If you are concerned that bonds are expensive, there are several things you can do to “play defense” and help preserve your capital:

  • Keep maturities short. The longer the maturity, the more negative the price impact if rates rise.
  • Stick with higher quality bonds. If you reach for yield, you are likely to end up holding junk bonds or other lower quality securities. So many investors have been buying these recently, that their absolute yields are low compared to historical norms (meaning they could be overpriced). When these markets turn, they can exhibit stock-like volatility. That usually isn’t what investors are looking for in their bond portfolio.
  • Be careful with closed-end funds. Some purchase these securities for their higher yields, but many of them are leveraged, meaning they invest with borrowed money. Leverage works great so long as the fund’s investments keep rising; but if they decline (as bonds would if interest rates rise), then leverage works in reverse and you lose money. Think about highly indebted borrowers in the housing market in 2008, and you get the picture. It can happen with any asset class. Avoiding leverage is difficult with closed-end funds since most use it, but only purchase non-leveraged ones if you can. At a minimum, know what your fund does with leverage and assess whether you can deal with the risk that may introduce.
  • Be careful with bond indexes in today’s environment. I am usually a fan of index investing, but in today’s world passive bond funds could be vulnerable. Many analysts think that the Treasury and government agency markets are some of the most overvalued. These sectors currently comprise large percentages of traditional bond indexes. For example, Vanguard’s Total Bond Market Index has a bit over 68% US government and agency securities, making it very nearly a government bond fund. Even if you have a positive view on these types of bonds, you’ll want to integrate other strategies into your bond portfolio for broader diversification.

It is also worth thinking about possible outcomes. Although someday rates will rise if they are to revert to longer-term historical levels, it is very difficult to say when they might do so. Many forecasters have been expecting rates to rise for a few years already. This is not to say that I am forecasting that rates will stay where there are. Instead, the point is that no one consistently gets rate forecasts right, and so we must use diversification as a guide for structuring our portfolios.

This is especially the case with unprecedented programs like that announced by the Bank of Japan. Some very expert investors, like Pimco’s Bill Gross, even think that the BOJ program could cause inflows into U.S. Treasuries.
http://blogs.marketwatch.com/thetell/2013/04/09/bill-gross-turns-bullish-on-10-year-treasurys-on-japans-bond-binge/.
But who knows? Even the esteemed Mr. Gross started to exit Treasury bonds early a couple of years ago.

So what is the message from all this? It is boring to hear this yet again, but stay diversified in your portfolios and make sure the risks you are assuming fit your situation.

Have You Seen the Latest From Washington? What it could mean for you

President Obama’s latest budget proposal should make everyone pay attention. While gridlock in Washington means these proposals are a long way from being adopted, the fact that they are being considered means we all need to save while we can under current laws governing IRAs and 401(k)s. For more on these issues and how they could affect you, please see an excellent article on this at
http://online.wsj.com/article/SB10001424127887324010704578416882575799330.html.

At the risk of sounding repetitive, save as much as you can while you still can with tax favored vehicles that exist under current law. There is just no telling where things may head.