2013 Third Quarter
"With interest rates at all-time lows, stocks continue to offer investors the best prospects."
- Jeremy J. Siegel, Kiplinger's Personal Finance, June 2013
Stocks, particularly U.S. stocks, have certainly been the place to be invested so far this year. As the above quote suggests, equities will most likely outperform bonds for the foreseeable future. That is not to say, however, that we will be resting on our laurels. We have been tweaking both the fixed income and equity sides of your portfolios over the past four months and may make subtle changes to your portfolios going forward. I thought I would spend the bulk of this letter updating you on my thoughts regarding two of the more substantial changes made to your portfolios and my outlook for the near term.
As mentioned in my previous quarter-end letter, the Chairman of the Federal Reserve, Ben Bernanke, made a statement on May 22nd that things were improving and the long-term bond purchases the Fed was making every month to help suppress interest rates (otherwise known as "Quantitative Easing" or "Operation Twist") may start to slow or taper by the end of this year as long as the economy continues to improve. We witnessed bond yields increase and bond prices drop pretty significantly across the board in May through July. When rates increased and the expectation of inflation dropped, the treasury inflation protected bond holdings (TIPS) were especially hit hard.
Over the past 10 years, an investor needed to be in intermediate bonds to receive any type of return outside of 2-3%. We just need to go back to 2012 to see that the PIMCO Total Return bond fund was up over 10% and the Vanguard Inflation Protected Securities bond fund was up close to 7%. Short-term bonds would not have come close to those returns in 2012. Going into 2013, investors knew that rates couldn't stay low forever. When Mr. Bernanke made his statement referenced above, I believe that was enough for bond investors to begin selling their intermediate and long-term bonds to dial back the risk and move into the safer short-term bonds and money market. I also took his comments to be the shot across the bow and that it was time to batten down the hatches. In other words, let's take more of the intermediate bond exposure off of the table and bring it back to safe (high quality), short-term (three years or less) bonds. Thus, after the trades I placed this summer, everyone should have their fixed income allocated as follows: 75% short-term bonds with the remaining 25% in intermediate bonds (the prior allocation was 60% short-term and 40% intermediate-term). While it may be difficult with the short-term emphasis to receive 10% and 7% returns from our overall fixed income portfolio, it will certainly keep the fixed income portion of our portfolio safer. After all, I prefer to take risk with our stocks and not with the bonds.
At the same time, I also tweaked our stock allocation. As you may know, emerging markets as well as Europe have had their challenges over the past five years. After seeing the U.S. market rally while international and emerging markets trailed, I figured that there is probably better value overseas than in the states at present. Thus, I have increased your foreign stock allocation to 23% of the total amount in equities from 20%. I am relying on our good, old fashioned value managers to pick among the stocks they consider cheap right now. I am less reluctant to index our foreign stock funds due to the uncertainties of dealing with other countries. There are more risks involved with overseas investing and I want to make sure proper due diligence is carried out for each and every company as well as each country prior to investing our hard-earned assets there.
I have had a few clients contact me about my reaction to what is going on in everyone's favorite vacation destination: Washington D.C. The markets are going to be choppy over the next few days and possibly weeks until the government shutdown and the debt ceiling are resolved. Regardless of the outcome, I believe this to be temporary and not a permanent loss of capital. Thus, I am inclined to let everything play out and NOT make any major changes to your portfolios. It is just too difficult to figure out when to sell and then when to buy back in. I would guess that if they came to an agreement and the government re-opens you would find a market relief rally, but it would be missed by those sitting on the sideline. Thus, I am inclined to stay where we are at. If you feel differently, please give me a call and we can discuss taking a little off of the equity table.
One point I would like to highlight is that the changes I mentioned above were also made in my family's personal portfolio. In other words, I eat my own cooking. As always, I am invested right next to you. Our interests are aligned.