1st Quarter Client Note

By Steven Smith | Investment Management

Apr 11

Reflecting relief from the New Year’s Eve (at least temporary) avoidance of the “fiscal cliff,” equity markets continued their strong recovery from the financial crisis of 2008. Economic activity in the US also continued to pick up, albeit at a slow pace. (On average, although fairly volatile from quarter-to-quarter, GDP continues to grow at about 2%.)

The S & P Total Return (including dividends) Index returned 10.6%, reaching a new all-time high. This was on top of a 16% gain for 2012. Average annual returns for the index for the trailing three, five and ten year periods are 12.67%, 5.81% and 8.53%, respectively. If we hadn’t actually lived through the Great Recession, we might ask where to look for evidence of it in the performance data.

Developed market international equities, while still positive, underperformed in the quarter. The MSCI EAFE Index returned 5.13%. But the EAFE Emerging Markets Index returned a negative 1.92%

Bonds or Shackles?

Investors focused on fixed-income investments are, understandably, on pins and needles. With interest rates at historic lows (driven largely by the Federal Reserve’s continuing aggressive monetary policy) they only have one place to go – and that is up. Of course, nobody knows when that is going to happen. Although, the Barclays US Aggregate Bond Index returned a negative 0.12% during the quarter – perhaps a harbinger of things to come.

A key investment concept is the inverse relationship between the direction of interest rates and bond prices. So when rates rise, the value of a bond (or portfolio of bonds) will fall – at least temporarily, until the bond reaches maturity. The longer the maturity of the bond(s) the greater the price impact. This concept is known as “duration.”

Low rates have caused many fixed-income investors to chase higher yields: either buying longer duration bonds (exposing themselves to interest rate risk) or taking on credit risk – buying low rated corporate (junk) bonds or the bonds of emerging market sovereigns. Or even buying leveraged portfolios of bonds, magnifying their exposure to rising rates.

Attraction to these asset classes has been fueled by recent performance on account of both falling yields and increased demand – ironically causing the current yields of these kinds of bonds to fall even further. As with any asset classes, this kind of performance cannot go on forever. The best estimate of the future returns is the current yield, which for the 10 year US Treasury bond is hovering around 2%.

For risk-averse investors – whose portfolios are dominated by bonds – this presents a difficult choice of either: 1) exposure to unaccustomed risks or 2) accepting lower yields and either reducing spending to preserve principal or eating into the nest egg their conservatism is designed to protect. For a great discussion of this conundrum, see this recent interview in Index Universe with the inimitable Dr. Bill Bernstein, Make Peace with T-Bills.

But for balanced investors (those whose portfolios have significant exposure to equities) this is a much easier dilemma. They can consciously limit their fixed income investments to only the highest quality and lowest duration bonds, taking their risk in equities (where the potential rewards are greater) and use bonds to control the risk of their overall portfolios.

Kipling and Buffet

Warren Buffet has famously quoted Rudyard Kipling in saying that the key to successful investing is “keeping your head when all about you are losing theirs.”  The trailing numbers reported above strongly demonstrate that sticking to the plan during the crisis proved to be a good strategy – rebalancing into stocks (or at least not selling) when many were panicking.  “Being greedy when others are fearful” – another Buffet aphorism.

By the same token, many of those sellers are coming back into the market now; five years into this historic rally. January inflows into equity mutual funds and ETF’s were at a record $65.5 billion. This suggests not becoming giddy, but maintaining the same strong discipline and rebalancing out of stocks when your portfolio becomes misaligned in the other direction.

More than ever it is clear that success requires a strategy that doesn’t demand a lot of tactical implementation. The need to make multiple decisions creates the opportunity to make multiple mistakes – and get pushed around by the markets in the process. But having a strategy you can stick with over decades does entail a great deal of fortitude. Nobody ever said that was going to be easy, either.




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