4th Quarter Client Note

By Steven Smith | Financial News

Jan 22

It seems like only yesterday that we were peering over the abyss of the fiscal cliff. Last New Year’s Eve, even after the 2012 elections were over, the political standoff appeared to be continuing. Taxes were set to rise, sequestration was about to kick in and the debt ceiling was once again about to be breached.

But an agreement on taxes was reached in January with the passage of ATRA. And a two-year deal on the budget was reached during December, following the 16 day government shutdown in early October.  This is actually the first budget passed since 2009.

The economy continues its arduously slow (2.0% annual GDP growth) grind out of the 2008 recession. And unlike during last summer’s “taper tantrum,” the Federal Reserve in December finally managed to issue a communication around the eventual tightening of monetary policy without spooking the markets.

With all this political and economic turmoil, who could have predicted that 2013 would have been one of the stock markets all-time best years? But it was.

A Historic Year for Stocks…And Bonds

The S&P 500 Index gained 10.51% in the quarter and 32.39% for the year; its best since 1997 – the height of the internet craze. 2013 also saw the return of the small cap and value premiums. The Russell 1000 Large Cap Value Index gained 32.53%. And the Russell 2000 Small Cap Index was up 38.82%. Foreign Markets did not fare quite as well; with the MSCI EAFE Index gaining 22.78%.

The bond market was another matter. With yields on the 10-year treasury rising from 1.76% to 3.03%, the benchmark Barclays US Aggregate Bond Index fell -2.02%; its worst loss in 19 years.

Getting A Rise Out Of Interest Rates

With the Fed’s December 18 announcement, we may be seeing the beginning of the end of five years of artificially depressed interest rates. There has been much sturm und drang concerning what that means for bond investors. Given the reciprocal relationship between interest rates and bond prices, many investors are convinced that bond portfolios will be decimated.  But there are a number of factors at play, most notably: 1) bond duration – the longer the duration the greater the impact. (While intermediate term bonds lost 2% in 2013, Barclays Short Term Bond Index eked out a .29% gain); 2) the rate of inflation and 3) the pace and magnitude of future rate increases. (When rates do rise, eventually the principal losses will be made up with higher income for investors who don’t panic.)

But predictions about bond returns can be just as difficult as those for stocks. The best predictor of future gains is today’s coupon rates – around 3%; 1-2% for shorter maturities. And to some extent, last year’s rate increases have already priced in future increases.

The main consideration for resolving this question is to understand the reason you have bonds in your portfolio. For investors who invest entirely (or mainly) in bonds and are using them for the purpose of generating returns, these are indeed difficult times; seemingly being forced to pick their poison. Many investors have been advised to abandon conservative bond strategies, in favor of extending maturities, buying riskier credits, venturing into emerging markets and even substituting dividend paying stocks for some of their bonds.

But for investors who hold bonds mainly to reduce the risk of an overall well-planned portfolio (in which they are already assuming the amount of risk needed to achieve their goals) the better strategy is to stick with short to intermediate duration, high quality bonds and continue to take the medicine served by the Fed.

It is exceedingly difficult to find a substitute for what these kinds of bonds contribute to a portfolio. Longer duration bond portfolios are more susceptible to losses on account of rising rates. And historically, extending maturities beyond five years has produced only modest marginal gains in exchange for that risk.

Repent and Rebalance

Just as it was impossible to predict that 2013 was to have been such a historically positive year, it is equally hard to predict when the next major bear market will occur. This is where the practice of rebalancing comes into play. Disciplined rebalancing allows us to skip the constant debate (such as the one between Wharton Professor Jeremy Siegel and Yale Professor Robert Shiller) about whether stocks are over or under valued. And it takes the emotion out of it, too.

Your investment policy statement has established the target allocation for the various asset classes, designed to balance risk and return over your time horizon. As the markets go up and down, allocations stray from their intended weights; both on the high and low side. Active rebalancing following periods of market extremes keeps the strategy in place. But this can be scary in real life. In the words of Warren Buffet, you are “buying when others are fearful and selling when others are greedy.”

For example, back in 2009 in the midst of the great recession after stocks went down 37%, it was advisable to sell some bonds and rebalance into stocks. Investors with the courage to do that have been rewarded over the last five years.

Now we face exactly the opposite situation. For the first time since the 2008 global financial crisis, we are seeing significant net positive money flows into stock mutual funds and ETF’s. (Of course, the herd tends to flee stocks during downturns and move back in when prices are higher.)  So it’s best to behave in opposition to the herd. The stock market has gained almost 200% from the trough in March 2009. The greatest rebalancing opportunities occur when stocks have moved greater than 20%, which happens approximately every four years on average.

Remember, rebalancing is not for the purpose of maximizing returns, but rather to maintain the risk/return characteristics of a carefully constructed portfolio.

 

 

 

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