The first quarter confirmed the slow but continuing expansion of a recovering US economy while new inter- national concerns have ignited. Each major US index has now surpassed prior highs set in late 2007, with the S&P 500 reaching its high in late March. Many analysts and managers have noted these accomplishments as a technical signal to end the secular bear market which has persisted for the past 13 years:
1st Quarter 2013
S & P 500 Total Return Index — 10.6%
MSCI Developed EAFE — 4.4%
Barclay’s Cap Aggregate Bond — -0.1%
While the S&P delivered the best first quarter since 1998, it is interesting to note that the aggregate bond in- dex delivered its first quarterly loss to investors since 2006. While one quarter slightly below break-even does not make a trend, we continue to exercise caution in the construction of our bond portfolios, and strive to avoid “reaching for yield” in an environment where talk of a “bond bubble” is now commonplace.
With equity results this strong, it’s easy to become a tad overconfident in our abilities as investment managers as we are experiencing a “Rising Tide Raises All Boats” environment. Indeed, many are now becoming con- cerned that perhaps the market run has made stocks too expensive. In looking at the numbers, it is easy to see why some may feel that way:
Over the past 16 years, the S&P seems to have developed a clear pattern of battling to the 1,600 level, then collapsing dramatically, almost as if on schedule. Using this time frame, stock investments look dangerous. However, if we evaluate our current position in the context of the longer term, we get a completely different picture:
Thus, it becomes clear why there is no magic formula that technical analysts can use to correctly predict the future direction of the markets in the near term. Instead, it becomes informative to look at other bits of evidence accumulating around our economy when looking for clues as to market direction.
There are some pretty clear indicators that at least the capacity for our economy to grow is improving. One clear observation from the recent financial crisis was that American households were living well beyond their means, leading to debt burdens their incomes could no longer support. This led to a precipitous decline in the values of the assets they borrowed against, and the economic downturn came to pass. Today, after 4 years of personal austerity, the household economic picture is improving:
Indeed, US household debt service ratios are the lowest they have been since the early 1980’s. As asset prices recover, net worth is improving as well. Household net worth actually exceeds levels reached in 2007. Thus, the American consumer is in a position to drive economic growth.
Additionally, while corporate economic activity has increased, our economically cyclical industries appear to just be hitting their stride, and many of these key industries appear to have plenty of room to grow simply to make up for lost time. Looking particularly at capital goods orders and light vehicle sales, activity is just now getting back to replacement levels.
However (as you can see to the right) new home construction, while having improved drastically, has quite a ways to go before we get back to normal.
So with all this capacity, what has to happen to get our economy moving in the right direction? In my opinion, the answer is simple: Consumers need to regain the confidence to utilize some of this capacity, and “consume” again. Less simple is the idea of what has to happen to generate that confidence. First, I will point out that despite all of the sound reasoning against it, consumer confidence is rising:
Though the positive move has been substantial since we last discussed it, we are still not to the point where consumer confidence can be considered strong. Should this trend continue, or better yet, accelerate, we may well see the type of shift in our economy that would benefit investment markets greatly.
This discussion then moves to “How can we build confidence in our economy”?. Well, policy debates have been extensive, and in the last 24 hours I’ve had the opportunity to listen to two noted global economists (Paul McCulley & Niall Ferguson) express wildly divergent views on how to make that happen. Ignoring what may be the “right” policy decision, I think it would be uniquely helpful if our political leaders set an example by serving to restore consumer confidence in our government. That would require negotiating in good faith, com- promise from all perspectives, and an end to finger-pointing and political manipulation for political gain. Should our government (I think I was remiss in calling them “Leaders” earlier) make progress on restoring public trust in the process, the economic gains could be unexpectedly bright.
Thus, it is unlikely that this will come to pass…but we can hope!
Looking at the markets today, I think a few metrics come to light when considering our portfolios. First, with yields at 200- year lows, it is difficult to accept the “return-free risk” of many bond issues. Further, even a small increase in interest rates will have a large impact on bond returns, and portfolios need to be prepared. This is demonstrated graphically to the right:
Yes, you are reading that graph correctly. A 1% rise in interest rates would create a price decline in a 30-year treasury bond in excess of 20%. That feels like an awful lot of risk for the prom- ise of a return of less than 3% on the same bond. While bonds still serve a function in the structure of your portfolio, that func- tion is now cash management, and expected returns are very low. No longer is their function to provide income or diversifi- cation from volatile equity markets. Their yield is simply too low for that.
An area of concern developing for me is the areas of high-yield (junk) debt and emerging market bonds. Mathematically, there are numerous arguments that there are still some opportunities in these markets, but beware: these are highly complex markets, and suitable only for sophisticated investors. Moreover, retail investor access to these markets has become easy and inexpensive, predominantly through the use of exchange traded funds (ETFs). Unfortunately, these ETFs do not come with a warning label and can be purchased by anyone, regardless of their knowledge of the underlying market or their ability to understand the associated volatility. Unfettered retail access to complex markets generally ends the same way, and junk bonds and emerging markets debt may be the next example.
Comparatively, domestic stocks are valued attractively by most every historical measure. In particular, the dividend yield is high relative to both our current inflation and bond yields. Ignoring growth, stocks now offer an income stream higher than that of bonds, which lead them to be a preferred asset class in this environment:
The attractiveness of high yielding stocks has certainly attracted the attention of investors in the first quarter, which saw the partial “fiscal cliff” resolution as it relates to taxation of dividends. Dividend stocks were largely shunned in 2012 over div- idend tax uncertainty, and with the resolution of that issue they have literally skyrocketed, perhaps somewhat indiscrimi- nately. These advances have been rewarding to our portfolios, but they reinforce the importance of discipline in equity se- lection as a means of managing risk. While our long-term economic perspective remains very positive, some of our more near-term indicators suggest the domestic stock market may be in for a few bumps in the coming months.
Another area of interest for us to watch is that of “complex” or “structured” investment products. Indeed, at a recent regula- tory conference, US regulators have expressed a growing concern that many principal protected structured notes and other complex products are being sold to investors for which they are not appropriate. One clue that you may be looking at a complex or structured product is if the prospectus describes the investment strategy in a way that looks something like this:
Now, as investment markets continue to evolve, I am a believer that incorporating “directional” strategies in your portfolio to manage risk is an important trend that should not be ignored. However, this is clearly a “don’t try this at home” subject. Your Cascade advisor can help avoid surprises, while providing access to highly qualified investment managers with con- siderable experience in these markets if we should decide to incorporate complex strategies. Before making any investment in complex or structured investments, you’ll want to understand how the product works and how it is designed to generate return.
Looking out for the rest of 2013, it is clear that our increasingly complex tax code will impact many of our clients. There is a great article on the impact of the new 3.8% investment tax (click here to view)1. This tax will have wide ranging implica- tions not only for hedge funds, but certain types of trusts. Additionally, individual investors will need to incorporate more active tax planning into their investment strategy as a result of this new tax.
While we celebrate the investment returns of the first quarter, and we look forward to continued economic activity over the long term, we are attempting to temper our expectations in the near term and structure our portfolios accordingly. Our ad- vice: Be smart and disciplined. Ask for help. Let us “keep our eyes on the ball” for you. Above all:
Plan Wisely – Invest with Confidence – Enjoy Life