This month’s commentary discusses the following topics:
- Second Quarter Markets Review
- Portfolio Implications
- Off to an Investing Conference
Second Quarter Markets Review
The second quarter went well until June, when Federal Reserve Chairman Ben Bernanke began to introduce markets to the idea that quantitative easing would not go on forever (please see the June 2013 post for details on his comments and the market’s reaction). That’s when things began to get rocky. The markets haven’t been sure that economic growth (especially on a global basis) is sufficiently strong for the Federal Reserve to reduce its stimulus measures. While the US is gradually improving, parts of Europe remain in a depression, and China’s growth is slowing.
In case you did not read our June comments, please be clear that rates increased due to fears that the Fed might pull back its stimulus. The Fed has not actually changed its policies, and went to great pains to try to explain that. But the markets were not buying it.
Despite the increased volatility, if an investor’s portfolio was balanced between asset classes, he/she wasn’t hurt too badly. The following summarize some observations on the markets:
- Cash was still “trash” (offering negative returns after taxes and inflation), bonds were a bummer, US stocks were still strong, and emerging markets were very weak.
- A lot of questions have been posed about whether the second quarter was a correction, a pull back, or a bear market. In some markets, the tone was definitely bearish, but for US equities, the declines were statistical noise. Note the strong returns in the table that follows for the year-to-date and one-year numbers for the S&P 500 Index (the average yearly return for the S&P since 1926 has been 9.8%).
- Sectors dependent on interest rates staying low or those investors have been purchasing for income as alternative to bonds were the ones that suffered most. Many of these are not shown in the table, but utilities and other high dividend paying sectors lagged.
- Other areas that suffered were commodities (particularly gold), and emerging markets. Commodities and emerging markets depend on growth in Asia, particularly China, and with Chinese economic growth looking weaker, those markets softened considerably.
- Gold was hit hard by many factors, not the least of which was greater competition from interest-bearing assets as rates rose. (Since gold pays no dividend or interest, the cost of holding it is low as long as rates remain near zero.) However, the declines were particularly vicious, and some analysts have raised questions about the amount of dumping of gold exchange traded funds. As is usually the case, fingers have been pointed at hedge funds as culprits.
|Large Cap||S&P 500 Index||-1.3%||2.9%||13.8%||20.6%|
|Small Cap||S&P Small Cap||-0.2||3.9||16.2||25.2|
|Non-US Developed Mkts.||MSCI EAFE||-3.6||-1.0||4.1||18.6|
|Emerging Markets||MSCI Emerging Mkts.||-6.4||-8.1||-9.6||2.9|
|US Bonds||Barclays US Aggregate||-5.3||-6.3||-8.0||-2.0|
|REITs||S&P US REIT||-1.9||-1.5||6.4||9.3|
|Gold||Dow Jones-UBS Gold Sub index Total Return||-12.2||-23.4||-27.2||-24.3|
|Commodities||Dow Jones-UBS Commodity Index TR||-4.7||-9.5||-10.5||-8.0|
Sources: AJO Partners, Factset, Dow Jones Indexes
There were a few interesting outcomes in the second quarter’s results:
- Asset classes diverged in performance, so that diversification was a benefit. This is in contrast to much of what we have experienced since the financial crisis in 2008, and is occurring despite synchronous loose money policies implemented by the world’s largest central banks.
- Although REITs are dependent on low-rate financing, the declines were rather moderate compared to the rhetoric in the press and to what one might have expected with concerns about the potential for change in Federal Reserve policy.
- A sector which investors have been purchasing for yield, the energy-related MLP sector, held up well and actually rose in value.
The observation on portfolio diversification bears repeating, especially since monetary stimulus has meant that in recent years, many asset classes have risen in tandem. If your portfolio is diversified, something will likely always be underperforming. Last quarter this meant bonds and commodities did poorly, but if you have maintained your stock exposure, your portfolio has survived intact. This reminder on diversification is something worth repeating to yourself every time we experience market volatility.
Since we covered what happens to stocks and bonds in rising rate environments last month, we’d also recommend referring to that post to become comfortable with your portfolio during times like these.
The rocky price action in some sectors has provided opportunities to rebalance your portfolio if it is already diversified, or to create a diversified structure if you have been waiting for an opportunity.
Importantly, the following comments are not intended to be speculative investment recommendations. Instead, these are tweaks one could make to a diversified portfolio that has been designed to fit your financial situation, risk tolerance, and most importantly, your risk capacity (risk that you can afford to take). Those who are clients at Kulig Financial will be familiar with all of those terms and concepts.
The following are just some of the areas an investor can consider. Many of them are in the bond sectors, but there are also some in the stock markets:
- For the first time in quite a while, we are seeing positive real yields on Treasury Inflation Protected Securities (TIPs). The stated yield on TIPs is called the real yield (meaning a yield net of inflation), while the principal is adjusted for inflation over the life of the bond. For quite some time, investors have been concerned about inflationary prospects due to loose money policies by the Federal Reserve, and TIPs became so popular as a way to hedge against inflation that yields actually went negative. In other words, investors were willing to pay the government to get the inflation coverage. With concerns about potential tightening measures, rates have risen across all bonds, and we now have positive, although small, real yields.
- Municipal bonds and emerging markets bonds were beaten down, so these markets may also represent opportunities to rebalance.
- Emerging markets stocks are trading at low prices relative to developed markets. Some analysts are finding this an intriguing area. Economic growth has disappointed year to date, although it remains at higher levels than in developed markets (which have also seen downward revisions to expectations). More recently the economic growth has been exceeding investor expectations, which tends to help these markets. Analysts have also noted that by some estimates the S&P 500 trades at levels roughly 45% more expensive than emerging markets. Of course, the fact that a market becomes relatively cheap says nothing about when it may rise in value. All you really know is that you have reduced the risk of overpaying.
- Gold is intriguing more analysts at these levels. They note that the macroeconomic concerns that make gold attractive (namely loose money policies which could eventually manifest in hyperinflation) remain in place. Gold is also an asset class (like stocks) that is volatile on a stand-alone basis, but very diversifying for a portfolio. Small weightings result in lower overall portfolio volatility.
In summary, with US stocks having had such strong results over the last year (and looking further 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 some have).
We have discussed reallocating to bonds in previous posts as stocks have risen this year. We would stand by those comments and reiterate them here for new readers (others can skip this section since you have heard this before).
Many ask 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 might consider in order to “play defense” and help preserve your capital (note: these strategies paid off in June’s rocky bond markets):
- 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. Many investors bought these earlier in the year and got hammered in the recent downturn for bonds. When these markets decline, they can exhibit stock-like volatility. That usually isn’t what investors are looking for in their bond portfolios.
- 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 have recently 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.
So where will rates go from here? The truth is that nobody really knows. Many knowledgeable veteran bond investors think the markets overreacted to Fed commentary, especially looking at the slow growth and continued unemployment in the US, not to mention that Europe looks worse and remain a drag on the global economy. But even if they are wrong, as we noted in June, it is possible to play defense with bonds, rather than desert them entirely.
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.
Off to an Investing Conference
Next week I’ll be heading to a conference in Newport, RI for a few days. The topics will range from how to attempt to hedge macroeconomic and market risks to investment opportunities, plus taxation issues and a myriad of other things. I’ve attended this conference for several years, and it is always interesting to see what the latest thinking is. While there really is nothing new under the sun, sometimes a new idea comes along that we later see a lot of in the market place. I’ll report back on this conference next month’s post.
Stay cool in these hot summer months, especially regarding things financial!