Quarter End Report June 30, 2013
As a strong quarter progressed, I became increasingly uncomfortable with the euphoria that seemed to be infecting investors, especially those who like interest sensitive holdings. Sure enough, the air was let out of that balloon with Fed Chairman Bernanke's comments in mid-May. He indicated that the Fed might let up on the credit creation gas pedal sooner than later, because the US economy appears to have gained a growth momentum that no longer requires dirt cheap credit to nudge it along. Horrors! Good news like this was anathema to many bond market participants, who have become addicted to ridiculously cheap credit. Panic ensued.
Along with bonds of all classes, interest sensitive sectors like MLP's, REITs and utilities took a hit, many falling 15% from recent highs. Because our clients are well diversified, and we had already raised cash levels, shrinkage was confined to low single digits.
Our policy for the past year has been to not replace existing bond positions when they mature or (more commonly) are "called" in by the issuers. I've bemoaned these early bond redemptions in previous newsletters because our clients' bonds are generally paying generous income, something nearly impossible to find today. Nearly all bonds we own are institutional grade, purchased between 2007 and 2010 when nervous investors avoided this asset class in the doleful days of the Great Recession. Most of the cash generated from bond redemptions or bond fund sales have been left in cash, as few bargain stocks were available, in my judgment.
Also, with interest rates at historic lows, it did not take a rocket scientist to guess that the next move for interest rates would be higher. Rising interest rates result in falling prices for the bonds and preferred stocks already trading in the market place. What few, including me, could predict, was that some seemingly innocuous words from the Chairman of the Federal Reserve (he said the Fed might "Taper" its bond purchases) would set off this level of selling. One wag described this as a "Taper Tantrum."
Equities, taking their cue from bonds, began their seasonal slump, just in time to confirm the Wall Street adage, "sell in May and go Away.") So, in June I've used the correction in certain stock prices to redeploy some of the cash built up in client accounts. In particular, I'm finding REIT's interesting once again, as many have seen their market prices fall to beginning 2013 levels, for no apparent reason.
Here's the performance overview:
Going forward, the strong foundation that income investments have provided to our clients' portfolios for the past five years may become less reliable, if the economy continues to grow. Rising GDP should translate into less Fed intervention. Interest rates would rise along with economic expansion at a gradual rate. Rapidly rising interest rates are damaging to the market value of income oriented investments, as demonstrated recently. However, if interest rates gradually rise, the value of income oriented investments should not be seriously dampened. But, economic expansion is not assured, or appears spotty at best. For the United States, at least, manufacturing is not booming. Retail activity is steadily improving, but sadly American retailers sell goods made in other nations, not here.
Housing is growing, which inspires consumer confidence, and is helping the auto industry, for example. But in my opinion, housing is very much an industry dependent on government welfare in the form of tax breaks and there appears to be serious discussions in Congress on limiting the mortgage interest deduction to $500,000 of purchase loan, and to zero on second homes. Even a wiff of uncertainty over the tax aspects of home ownership could slow sales. In other words, the foundation for recovery appears of questionable sustainability. The real bright spot for Team USA appears to be energy production, transportation and refining, an area in which our clients are heavily invested. So, US economic prospects seems OK, but the pace of recovery appears unlikely to quicken from its sluggish level near 2% per year. If this continues, rising interest rates will not be a threat. The behavior of bonds in the waning weeks of the last quarter, however, was a reminder that this usually quiescent investment class can wake up quickly, and in a bad mood!
After a relatively tame few months following the November elections and the "fiscal cliff", financial market volatility seems to be rising again and may figure as an unpleasant feature in the near future. Our clients' portfolios were crafted to keep volatility low. When things went badly in the Great Recession, their losses were only half those of the equities markets. When things went badly in the most recent quarter, their losses were also tame. But the trade-off is this: if I'm wrong and we are entering another bull market bubble for stocks, our clients' portfolios will seem to "underperform." In fact, over the past year it has underperformed stocks, as I knew it would, if stocks were particularly strong, as they have been. Still, most clients are up over 7%, with low volatility. My job is to protect my clients' assets from a sudden, devastating market crash (whether stocks, bonds, gold or real estate). My clients have been kind in expressing their support for this approach, which lies somewhere between owning riskless CD's at .75% yield or playing the stock or gold or real estate game with periodically great returns followed by nearly certain collapses. In crafting a portfolio for our Balanced/Value clients, I take my cue from something with which we are all familiar: freeway driving. If you want to reduce your risk of a very bad accident, drive a little slower, a little more calmly and the odds are pretty good that you will arrive at your destination unruffled and in good condition.
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