• Bill Bullock

2010 Third Quarter

After a disappointing second quarter, the third quarter returns were more appealing. Most of our mutual funds beat their respective indices, but some fell a bit short. Our fixed income funds continued to outperform, which has many thinking there may be a bond bubble. Regardless, let's hope the third quarter returns are something we can build on in the next three months.

I don't think you could write about the third quarter without discussing the "macro" (overall economy) vs. the "micro" (individual corporate earnings) news. It seems to me that there is a tug-of-war between these two forces right now.


The macro news hit us especially hard during the second quarter of 2010 with the debt crisis in Europe. While there are still concerns in Euroland (e.g. Ireland), the news has calmed down. Meanwhile, the Federal Reserve has turned their attention to the prospects of deflation, a decrease in the general price level of goods and services. While deflation may help the consumer in the short-run, the long-run would be a different story. During deflationary times, corporations and individuals would quickly stop re-supplying their inventories since they could buy their supplies cheaper two weeks from now or maybe six months from now. This would result in a spending freeze which would then have drastic and dire implications to the entire global economy. It is in the Fed's best interest to make sure corporations and consumers know that there will be some small amount of inflation in the future. "Buy your supplies now before they become more expensive six months from now!" would be the Fed's mantra. Moreover, when the average person or corporation can borrow for less, that means that they are likely to spend more. In anticipation of all of these events unfolding in the next few months and years, the stock market rallied significantly in September which has been, historically speaking, an extremely difficult month for stock returns. A higher stock market also helps quell deflationary concerns. If you are wealthier or feel wealthier, you are more inclined to spend more. While that may be true for most consumers, I would argue my clients like to save more, right?


The micro news has been good. In fact as I write this letter, Google has beaten analyst earnings expectations for the third quarter of 2010. Many other companies have reported similar results due to in large part their cost cutting initiatives that took place in 2008 and 2009. As I have mentioned in previous letters, earnings are extremely important for the stock market to continue its upward climb.


Over the last 15 years we have had a stock market bubble and a real estate bubble. Many in the media believe we are now due for a bond bubble. While we have had a significant run-up in bond prices, I believe we may be in for a few more months of historically low interest rates and elevated bond prices. Goldman Sachs and the PIMCO fixed income managers believe the Fed will not begin to increase rates until 2012. A bigger concern may be if the stock market continues its incline, we may have investors selling their bonds and buying stocks. This effect would increase the intermediate and long-term rates by lowering the demand for bonds.


With the majority of our fixed income exposure in short-term bonds (i.e. three years or less) with the remainder in intermediate-term bonds (i.e. five years or less), I believe we could ride out whatever hits us as long as we are willing to hold on to some of our fixed income for a couple of years. In other words, we will need to maintain that long-term bias of "buy and hold". Nevertheless, I will monitor this situation and may decrease our overall fixed income average duration if the investment climate warrants. In the meantime, we will enjoy the 9.61% year-to-date return we have received from the PIMCO Total Return fund. By the way, we have very little junk, or high yield, bonds and very few long-term bonds mixed in with the intermediate bond funds; I believe these areas are too risky.

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