The Land of Opportunity?

By:  Douglas Schwartz

A few weeks ago, I had the privilege of hearing the co-founder of Home Depot, Bernie Marcus, speak.  There was one thing that Mr. Marcus said that I have been unable to get out of my head.  He said that if he were trying to create Home Depot today, he would simply not be able to do so.  He went on to add that in the 1970's, Washington was your friend.  They used to help and encourage free markets, business and entrepreneurship. Today, making money and becoming wealthy is demonized.  Washington is increasingly becoming your foe.

All of the outrageous legislation and regulations are hindering the ability for Americans to start and grow businesses, which obviously has a negative impact on job creation.  For example, let's talk about the Dodd-Frank Act which greatly increases regulation in the financial services industry.  It was passed in July of 2010 yet bureaucrats are still adding regulations to that bill to this day.  As of April 1 of this year, only 52% of the rules mandated by the legislation were completed. Yes, you read that correctly.  All this red tape is making it more difficult to start a business in the so called land of opportunity than other countries. For example, it takes six months to start a bank in England.  It takes three years to start a bank here in America.  It is easier for someone to come out of poverty in China (Jack Ma) and create a thriving business, than it is to here in the USA.   What's wrong with that picture?  I can think of at least one thing.

The problem stems from our citizens, most of us are simply not informed.  As a country, most people vote for the party their parents align with, for selfish reasons, or maybe even for whoever has the best one-liners.  This is another subject Mr. Marcus is outspoken on.  He says it's time for voters to get their emotions under control and look at the facts.  Frankly, most people care about themselves more than their country.  But in their defense, it is hard for people to truly understand the bigger picture.  In terms of economic policy and global economics, just last month, the International Monetary Fund basically admitted that they are out of ideas on how to get the global growth engine running.  More specifically, IMF Chief Economist Olivier Blanchard was quoted in a WSJ article earlier this month saying, "There are two forces at work weighing down prospects: the legacy of high debt and falling growth potential in the future."  All this big government fiscal policy is not working. We have had an accommodative monetary policy (near zero interest rates and quantitative easing) for far too long that has masked the true problems and allowed crushing fiscal policy to take root.

We simply cannot afford to stay on this current trajectory.  Our national debt is out of control.  Mr. Marcus has stated that if we stay on this path of government spending, we'll be in no better shape than Greece, Spain and France, but with no one to bail us out.  We will not see all the consequences of our current government's actions for decades to come.   It is easy for politicians to make promises that feel good, or for them to borrow money now and spend the borrowed dime to push their agenda.  But make no mistake.  We will pay for these crimes one day.  Our leaders are stealing from the next generation.  $17,898,691,021,355.14 and counting in national debt is a big problem.  This number doesn't even come close to including the government's unfunded obligations to Social Security and Medicare.

We have a very important election coming up. Before you go to the polls on November 4th, take the time to educate yourself on the candidates and how each of them stands on important issues.  It is time that we the people take a stand and let our politicians know that this out of control spending and blame game has got to stop.  I want to live in a country where our government encourages entrepreneurs like Bernie Marcus, not hinders them.

A Map Would Be Helpful - Part 2

By Charles Webb

For those who have been paying attention to the stock market the last few weeks, there’s little doubt that it’s been a little nerve racking.  Our clients will have or soon get our latest market commentary in their quarterly reports (see previous post).   In that commentary, we’ve addressed some of the reasons that we feel the market has sold off this month.  However, since then, we’ve seen even more volatility and a further selloff in the global stock market.  We wanted to send out this brief note to address the last few days’ activity.

As of this writing, stocks have had more days of triple digit declines, including an intraday move of -350 points on the Dow Industrial Average.  This has essentially put all the indices in negative territory year-to-date.  While the international concerns mentioned in our commentary are still the primary drivers, other news seems to have amplified this negative sentiment, the Ebola scare being the primary headline. 

Experience tells us that this piling on effect is fairly common.  When stocks top out, such as what we saw this summer, investors get nervous and begin looking for reasons to sell.  Initially, you’ll see the various parts of the market diverge from each other as investors naturally pull away from the more richly valued sectors.  We saw this trading pattern in September as the small and midcap sectors underperformed large caps. 

News concerning fundamental factors such as GDP and earnings drive most of this initial selling, but from there things tend to get irrational.  Once again, the Ebola news would fall into this category.  This is what you’d call “headline risk”.  There’s no reasonable explanation at this point to link stock market performance to something like a few people in the U.S. contracting a virus.  What it does, though, is create a catalyst for those looking for a reason to sell.  The trading jargon for this is “capitulation” and the financial news loves to report on it.

Whenever stocks reach historic highs, it’s necessary to have a periodic retreat to consolidate those gains.  Investors are never comfortable when things go straight up.  They always expect there to be a selloff.  Once that occurs, the feeling is that it’s now behind us and it’s safe to get back in.  You’ll hear a lot of talk of “10% corrections” and technical terms such as “200 day moving averages” being thrown around.  This is all just an effort to figure out when the sellers are done.

We never felt that 2014 was going to be a particularly good year, but we do believe it will finish positive for the year.  The good news is that bonds continue to rally.  For those who like to frequently look at their account balances, that will help. 

A Map Would Be Helpful

By Charles Webb

The title of this quarter’s commentary is derived from what seems like a complete lack of direction in both the stock and bond markets.  There certainly has been no shortage of news for the financial markets to respond to, but much of it has been conflicting and of questionable importance.  Weeding through the headlines of the last quarter, the larger drivers of the U.S. market performance have been shifting Fed policies, U.S. dollar valuation and foreign growth trends.   

After years of unprecedented market intervention, the Federal Reserve appears to be ready to end its bond buying program, known as quantitative easing, and eventually raise interest rates.  We’ve just started to see the technical details of how they plan on accomplishing this, but there’s still little consensus among board members of when these policy changes should take place.  The primary task at hand is to raise short-term rates from essentially zero to a preferred 2% without adversely impacting the economy.

The Fed has announced that it will end its six year experiment in long-term rate manipulation this month.  Through QE 1-3 and Operation Twist, the Fed has successfully propped up asset values, such as the housing market, by buying Treasury and mortgage-backed bonds in the open market.  The Fed now holds roughly four and a half trillion dollars of these bonds in its portfolio.  We’ve seen relatively little volatility over the last number of years and that has been largely attributed to the Fed’s market interventions. Now the principal question is how the markets will respond to the various economic uncertainties in the world without the Fed’s safety net. 

The answer to that question, we may need to look no further than the last few weeks of market volatility.  The past two weeks in particular have seen a reemergence of back to back days of the Dow Jones Industrial Average whipsawing hundreds of points in either direction.  Driving these swings are economic concerns abroad.  While slow growth in Europe is nothing new, what is new is the absence of a response from our central bank – the Fed.

The European Central Bank cut interest rates in June and September, when it also announced a bond-purchase program. These measures are designed to combat anemic growth and low inflation in their economies. Meanwhile, the Bank of Japan, too, is considering whether to enhance its bond-buying program to raise consumer prices and boost growth.

These moves and others have led to a reduction in the value of the foreign currencies relative to the U.S. dollar.  The stronger dollar in turn has put pressure on corporate earnings as our exports become less price competitive.  In previous years, these moves would have been offset by the monetary expansion that comes with quantitative easing.  Absent that, the markets are unsure as to where the dollar will stabilize and what the ultimate impact on corporate earnings will be.

As of now, the recent selloff has erased this year’s modest gains and actually pushed most indices into the red.  Large cap stocks have fared the best from a total return standpoint at near or just above breakeven.  The small cap sector, on the other hand, performed the worst, losing around 7% thus far.

The bright spot has been in the bond market.  The benchmark 10 year Treasury bond has rallied considerably since the spring.  We’ve seen the yield drop from as high as 3% at the end of last year to its current level of 2.2%.  While this has been good for bond prices, it hasn’t been good for those seeking income. 

We view all of this as temporary, as the markets attempt to find the right trading levels in a world without the Federal Reserve market interventions.  We’ve been stating since last year that we felt this was going to be a mediocre year for stocks.  For most of the year that has been true.  We still hold out hope that this recent selloff will be temporary and that we’ll see values pick back up by the end of the fourth quarter. 

Income is still king in our book.  Our total return focus has taken our portfolios into more diverse areas of the market.  These include the addition of convertible bonds, expanded use of Master Limited Partnerships (MLPs) and preferred stocks. 

Generating cash flow continues to be a challenge for investors and we look forward to higher interest rates in the near future.  Investors need a break from the Fed’s easy money policies.  We’ve been concerned for years about the credit risk average investors have to expose themselves to in order to meet their income needs.  Although higher rates typically put pressure on the stock market, we feel this is necessary in the long run to achieve a more balanced and risk appropriate investment strategy. 

Religion, Politics, Sex and Money

By:  Charles Webb

Which of these subjects are Americans least likely to want to talk about? Based on several surveys, including ones from Northwestern Mutual Life, Wells Fargo and T Rowe Price Group, the subject of money is the least desirable topic that Americans feel comfortable discussing with friends or family.

 

The subject of money is a funny thing. After all, money is the one thing that we can pretty much all agree on - more is better, we're all working hard to acquire it and it buys us the things we like to show off to others. However, when it comes to openly talking about it, taboo is the word. We frown at others who talk about money in polite company, we keep our wealth a secret from our children, and we hide the truth (either better or worse) from our peers.

It's not that money isn't on a lot of minds. Those surveyed by Northwestern Mutual rated personal finance a top priority (second only to personal health), and the majority felt their financial planning could use improvement. Yet according to the survey, 42% have never spoken to anyone about their retirement and only 39% have spoken to their spouse or partner about the subject.

In our business, we see this phenomenon in many ways almost every day. On one end of the spectrum, you have very wealthy people who are worried that they'll be a target for others. On the other end are people who may feel ashamed of their situation. Then there are the countless situations in between.

While it's generally a good idea to keep your cards close to the vest as the saying goes, when it comes to your family, it is a good idea to be more open about things. This is especially true with adult children and aging adults.

From the adult child's perspective, understanding the parent's financial situation can alleviate uncertainty as to whether the parents will need support from their children in the future. Without planning, the burden of supporting one's parents can lead to significant marriage problems for the benefactor and resentment among siblings. Proper planning ahead of time can give all those involved time to discuss how the giving will take place and what the tradeoffs might be. For example, one sibling may contribute financial resources and another may provide personal resources such as directly caring for an ailing parent.

From the parent's perspective, early conversations are always helpful when it comes to estate planning. However, few parents want to dwell on their mortality-a subject that may also make the children uncomfortable. Parents may also dread sparking family squabbles about who's getting what, or worry that once the children know what's coming to them they'll become entitled, unmotivated heirs. But the benefits of getting everything out in the open can be enormous, both emotionally and financially.

Telling children ahead of time what to expect allows parents to explain their decisions and it allows the children to plan their lives accordingly. Plus, feedback from the children can be an eye opener, prompting parents to make wiser decisions about their wills, and there may even be a tax benefit in some cases.

When it comes to multiple children, there is plenty of room for resentment among heirs over the terms of a will. Those resentments can last their lifetimes, too. But talking things out while the parents are alive may help soothe hurt feelings. Parents can use this opportunity to explain things in their own words instead of the cold legal language of a last will and testament.  

Parents may choose to speak with each child individually or in a group, depending on family dynamics. Sometimes the individual approach makes it easier to discuss potentially sensitive issues such as unequal distributions, the use of trusts versus passing on wealth outright, or selecting one child over another for a fiduciary role.

Another huge benefit is to inform the children what they'll be dealing with. This can range from who the executor is to where all the accounts are located. That last thing a grieving family should have to deal with is hunting tax returns and bank statements trying to figure out where their parents held all of their accounts. The business of death should be minimized to the fullest extent.

Lastly, the children may actually have a better idea as to how the estate should be divided. Parents often think they understand the family dynamic but could be completely wrong when it comes to adult children. If the kids can agree among themselves ahead of time, those changes can be easily implemented while the parents are still alive.

The bottom line is that money conversations are an important part of maintaining healthy family relationships. All too often these conversations are overlooked or just avoided. While the benefits are obvious for the wealthy, it's also important for those of more modest means, too. Choosing when the kids are mature enough or responsible enough may be a challenge, but the subject eventually needs to come up.

Another Retailer Data Breach

By Lori Eason, CFP(R)

I’m sure you’ve heard about the latest large retailer affected by a security breach, Home Depot.  I personally received a text from my credit card company on Tuesday asking about a “business services” purchase of $49.95.  It was a fraudulent charge and I’m thankful Chase caught it and declined the charge right away.  Of course this meant I had to cancel my credit card effective immediately, and everything I have on auto-pay has to be updated.  But this is a small price to pay considering the alternative.  I took a close look at my statement and had another fraudulent charge for the same amount on 8/13.  This prompted me to double check all of my statements since the beginning of the year, but fortunately didn’t find any other suspicious charges.  I’ll never know if I was a victim of the Home Depot breach, but considering we have spent the month of August remodeling our kitchen, there’s certainly a good possibility!

Clark Howard has some good pointers on this subject in the following article:

6 Things You Need To Know After Any Retailer Data Breach

By Clark Howard

ClarkHoward.com

It's the latest in a string of high-profile breaches that has included Target, the Heartbleed breach, eBay and Lifelock, and the Russian hackers getting 1.2 billion usernames and passwords.

And now, in the midst of a severe case of "breach fatigue," we're getting word of the Home Depot data breach.

This one is still a moving target (no pun intended!)...but it could be larger than the Target breach that impacted more than 100 million customers late last year. Regardless of how the final numbers shake out, there are some things you need to keep in mind whenever you hear about these increasingly common data breaches.

Expect news of more breaches for the next 2 years

Our nation's banks were woefully behind the rest of the world when it came to investing in secure chip and PIN technology. We're the last place on Earth that uses '60s era magnetic strips on our cards; that's why all the criminals target us! The banks are only now making the wholesale switch to new safer technology, but that will take at least 2 more years. That's just the sad reality.

I think it's particularly important to know the retailers -- whether you're talking about Target, Home Depot, or anybody else -- are not at fault here. The blame lies with the banks.

Watch your statements carefully

If you're among those hit by the Home Depot breach, you need to go through your credit card and debit card statements this month and next month with a fine tooth comb. Identify any bogus charges the crooks may have pushed through and dispute them immediately with your bank or credit card company.

Use an abundance of caution

This is a time when you need to beware of anyone calling or emailing you trying to impersonate a breached retailer or your bank. The cons may ask you to click a link or to verbally confirm additional personal information over the phone.

When in doubt, hang up the phone or close out the email. Then call your bank or visit the merchant website to verify the legitimacy of the request.

If you remember one thing, it should be this: Do not click on any links in emails that come related to this or any other breach!

Limit the risks from debit cards by setting up a separate account

The reality is customers who use debit cards are hit hardest by any breach. If you wish to continue using debit in the future, be sure you tie it into a separate account that's only used for debit transactions. I like to call it your "walking around" money. That way, only that money you transfer to your separate account is at risk in a breach. Not the money you need to pay your mortgage or a car note, or to put food on the table.

Understand the real dangers of debit vs. credit

To understand just how bad debit cards are, you first have to look at the consumer protections afforded to credit cards. In a case like this breach where crooks potentially have your credit card number but not the physical card, normally that means zero dollar liability. In the worst case scenario, your maximum liability would be $50…and some issuers will waive even that.

If you used a debit card though, it's a whole different story. Debit cards are dangerous to your wallet. They don't have the normal protections under federal law offered by a credit card.

With a breached debit card, you have only 2 days after you notice that money is gone from your account...or else your liability rises to $500. And under some circumstances, your liability with a debit card can be unlimited.

You should do a credit freeze right now

You'll pay zero to $10 per bureau, depending on your state. This will shut a criminal down cold when they try to apply for new lines of credit in your name. You can find my credit freeze guide here; it will walk you through the easy process.

Creative Destruction

By Charles Webb

Economic issues have been a major concern for upwards of six years now. And while the economy and job market have improved over the last couple of years, our growth and employment rates seem to be stuck in second gear. Of these issues, the reasons for the long-term unemployed and what to do about it has become a hotly debated subject.

One of the questions raised is if a 6% or higher unemployment rate is going to become the new normal in the United States. This fear of us having a chronically high unemployment rate is based on several evolving factors, but a reoccurring topic is what role technology will play in the job market going forward.

Last month, Harvard University economist Lawrence Summers published an essay in which he envisioned a world in which computers and machines displace a vast new array of human work, creating an economy that produces few opportunities and sources of income for actual people.

Driverless trucks and taxis or drone package delivery don't seem that farfetched in this day and age. Shopping is more frequently done online and automated warehouses retrieve and ship packages efficiently with only limited human assistance. Even consumer habits seem to eliminate jobs. When was the last time you had someone pump your gas? Did you even pay the cashier or just swipe your card at the pump? Taken at face value, we seem destined for a world run by machines that maybe don't even need humans.

But the truth is there is nothing new in these changes. There's a long history of technologies displacing human labor. The green revolution displaced labor from farming. The industrial revolution replaced skilled artisanal labor with unskilled factory labor. The mass-produced automobile drastically reduced demand for blacksmiths, stable hands, and many other equestrian occupations. Successive waves of earth moving equipment and powered tools displaced manual labor from construction. In each case, groups of workers lost employment and earnings as specific jobs and accompanying skill sets were rendered obsolete.

However, along with these changes came opportunities in new industries that never existed before. In today's Internet age, those industries have names like Search Engine Optimization and Big Data Analysis. How big are these new players? The answer is really big. The industry that collects, analyzes and sells consumer data from our online activities is a multibillion dollar enterprise. Then there are the thousands of software developers and coders that will be needed to support the smartphone industry alone.

You'll often hear these dislocated workers referred to as "victims of the capitalist system" and see rules and regulations set up to prevent these kinds of changes.   In reality, this is a sign of progress and ultimately leads to higher productivity as a nation and a higher standard of living for everyone.

From the beginning of the industrial revolution, politicians and labor unions have attempted to keep the status quo. In 18th century England, riots would break out as workers destroyed the newly invented steam powered textile equipment that threatened their jobs. Labor unions arose to fight against the profit-hungry factory owners. Two centuries later, union negotiators would have the auto manufacturers limit the number of robots installed on the assembly line as part of their contract. In hindsight, these efforts now seem futile and counterproductive.

Policies using the government as the employer of last resort have also been attempted. The famous economist Milton Friedman once visited an Asian construction site where a dam was being built. He couldn't help but notice that instead of heavy machinery, thousands of workers used shovels and wheelbarrows. When he asked why, the government official explained that it was to insure more work. Mr. Friedman in turn asked, "why not use spoons then?"

In the future, machines will likely have a larger effect on a specific type of work done. Repetitive jobs that pay above average wages are the most likely candidates to be lost to automation. Low wage work isn't worth the investment and high end work tends to require abstract thinking not easily mimicked by computers.

Either way, in the long-run, the economy and workforce finds a way to adjust. There is no better proof than the fact that through all the years of innovation, the economy has continued to employ more people than in the past.

Fighting Electronic Fraud

By: Lori Eason, CFP(R)

This day in age, technology is a major part of all of our lives. But with the convenience of unlimited data at our fingertips comes an increasing number of opportunities for thieves. If you haven't personally been the victim of online fraud, you probably know someone who has. In our line of work, security is of utmost importance. After all, we manage people's life savings. In a recent survey among financial advisors, 25% said they had received what appeared to be a fraudulent request for funds in the last 12 months, and we can be included in that number (we saw through the fraudulent email). Although we have always been extremely cautious and have many security measures in place, we stay up to date on new risks and look for opportunities to further protect our clients. Just as technology evolves, so do criminals.

As a firm, we combat these evolving threats by investing in a wide array of security devices and software to protect our servers and network. In addition to this electronic security, our equipment is kept behind locked doors and we have strict user policies to prevent security breaches from occurring as the result of unsafe online activity. Our electronic systems are secured in much the same way as most other corporate networks. While no system is impenetrable, servers by nature are pretty safe and are not the problem with most electronic break-ins. The greater risk is individual computers.

In my role here as a financial planner at Alder Financial Group, I am constantly corresponding with clients via email. Sometimes this includes emailing sensitive attachments including account forms, statements and quarterly reports. While I don't worry about the security on my end due to all the layers of protection we have in place here, if one of our client's personal email accounts was hacked, there is a chance that personal information could end up in a thief's hands. We recently started using a secure, electronic filing service called ShareFile. This is one step we are taking to strengthen our security and reduce the risk that one of our clients becomes a victim of fraud. Instead of emailing account sensitive attachments, we plan to upload such documents to ShareFile. Our clients can then securely login and download the documents, and store them there if they so wish.

While we are taking steps to increase our security, there are things you can do as well. First off, it is very important to routinely clean out your email inbox. If you have received emails and attachments with personal information, download and save the ones you need to keep on your computer and then delete the email. Keep in mind that just because you clicked delete does not mean that you have permanently deleted the email. It may be stored in a "trash" or "deleted" folder. You'll need to routinely clean up and delete your sent emails as well. It's also important to be careful when using public Wi-Fi hotspots. It's safest to not transfer personal information over such networks as they may not be legitimate connections. A scammer can easily sit in their car outside a Starbucks and broadcast a fake Wi-Fi network from a laptop.

In a recent article in Financial Planning magazine, I read a scary example that could have ended very badly for a financial advisor and her client. The advisor knew her client was looking for a new house to buy. But she was a little surprised when she received an email from the client asking her to wire money directly to the seller for a closing scheduled for the next day. At first the advisor was annoyed about the short notice. It turns out a thief had hacked the client's email account and read enough emails to learn about what was going on in her life. While the advisor was getting the funds together for the closing, she decided to call the client as things were just moving too fast. Sure enough, the client wasn't closing for several weeks and hadn't sent that email to the advisor.

The internet is a great resource and makes all of us far more productive. You shouldn't let the threat of online fraud prevent your from using this valuable resource. Many people mistakenly think that the biggest risk with corresponding electronically is in the transmission of information over the internet, but in reality, the larger threat is what happens to the information once it reaches its final destination. With a few simple steps of keeping your inbox clean, you can greatly reduce the chance of someone getting their hands on data that could be used to commit crime.

Interest Rates: Should I be worried?

By Alan Gaylor

 

With three months of the year behind us, we thought now would be a good time to reflect on what happened last year and examine how the bond market is expected to fare going forward.

 From a historical perspective, 2013 can be viewed as a transitional year for bonds. Over the last thirty years, we have seen a persistent decline in interest rates. With rare exceptions, these have been great times for bond investors. The falling interest rates have lead to very good risk adjusted returns from most bond-like investments. I am proud to say our clients benefited greatly. As we have written about many times, when the Federal Reserve forced rates to their lowest levels in many generations, we knew it wouldn't last forever. Last year was the first sign we saw that proved that point. Given our experience as bond investors, we watched closely as last summer unfolded and the Federal Reserve began to hint that it would start to slowly remove (taper) its Quantitative Easing policies. Because rates were low and so many investors were expecting rates to increase at some point, the mere mention of the Fed's actions sent rates spiking up during the early summer. Due to those two months of rising rates, 2013 turned out to be the second worst calendar year on record for the Barclay's Aggregate Index, which had a negative return of 2.9%, and only the third negative total return for the index (data going back to 1976). The other negative return years were 1994 and 1999. Unfortunately, amid the 30% gain in the stock market last year, it doesn't seem that many paid attention to how bonds performed. We did. Our whole bond investing thesis has been built around how to generate income when yield is hard to come by. That thought process protected us very well last year. Diversifying our streams of cash flow proved to be the right combination. However, we have to be mindful that the interest rate environment we currently face is, and will continue to be, tricky. We don't need any more evidence than last year to prove that point.

 

What about this year?

 

We think it has been generally acknowledged that the next big movement in rates will occur when the Fed actually begins to tighten interest rates. Fortunately, most indications are for those events to play out in the future rather than now and 2015 seems to be the consensus as to when that may start.

 

Much like the last few years, this year's bond performance will mostly likely depend on the type of bonds you own rather than simply being in the bond market in general. Given that we are poised to have higher rates at some point, it has been advisable to minimize interest rate sensitive bonds, such as treasuries, and focus more on credit sensitive areas, such as investment grade and high yield corporate bonds. While it is still early in the year, credit sensitive areas have indeed performed better than the broader market indexes that are comprised of primarily government (interest rate sensitive) bonds. We currently believe it is prudent to employ bond portfolio strategies that give our clients exposure to many income producing sectors such as corporate bonds, high yield bonds, bank loans, municipal bonds, preferred stocks, and MLPs. The idea is that by diversifying your sources of cash flow, you will lower your overall risk to interest rate changes while still generating income. Another way to lower your interest rate risk is to manage a portfolio's duration risk and try to stay somewhat shorter in maturity.

 

While we do not think the Fed will surprise the market this year with rate increases, we have to be cognizant that the market itself can put upward pressure on rates. We would expect this to occur as our economy continues to show improving performance. Interest rates and economic growth measures go hand and hand. Interest rates generally move in a sequence: the economy improves, interest rates increase, inflation worries materialize, and eventually the Fed will tighten interest policies to fight inflation. This will ultimately happen, but leaves us with the question of when. The Fed policies are very data-dependent at this point. We say just stay tuned.

 

Why bonds?

 

If we are facing an environment of low yields, higher interest rates down the road, and a booming stock market, do we even want to own bonds? The simple answer is, of course you do.

 

Let us remember that the primary purpose of bonds in an investment portfolio is not to solely attempt to generate high returns, but rather more stable, predictable returns and to act as ballast during bad times. We own bonds because we place equal importance on diversification and risk mitigation, in addition to performance considerations. After all, bonds and stocks are completely different animals. Bonds tend to protect against the worst kind of market risk-the times when stocks suddenly, unexpectedly plunge. Prior to 2008 and just before the credit debacle began, U.S. equity markets seemed to be sailing toward another year of gains. At that time, investors were also asking, "why own bonds in an environment like this?" Yet by the end of the year, a mixed portfolio of bonds had achieved a 5.24% positive return, while stocks declined by 37%, meaning bonds outperformed stocks by more than 42 percentage points. That is a classic example of limiting risk. Moreover, in 2000, 2001 and 2002 when stocks dropped 9.11%, 11.89% and 22.10% respectively, bonds rallied to give investors returns of 11.63%, 8.43% and 10.26%. 

 

Bottom line, investing in bonds is still one of the best ways to provide protection against the unpredictability of stock market returns. You just never know whether a 2002 or a 2008 is lurking somewhere around the corner.

A Rough Start

By:  Charles Webb

I think we can all agree that 2014 has gotten off to a pretty inauspicious start in the stock market.  After a fairly flat open through the first half of January, the stocks have dropped almost every day since mid-January.  The Dow Jones Industrial Average has shed over a thousand points in roughly two and a half weeks, often by triple-digit daily declines.  On a percentage basis, a thousand points isn’t what it used to be, but it’s still hard to watch.

The decline has been partially driven by currency volatility in certain global markets, but the real underpinnings of the selloff in the U.S. have been a mediocre fourth quarter earnings season. 

In our most recent market commentary, we noted that stock valuations have become relatively high by historical standards and we felt that the forthcoming earnings announcements would be weak.  This now seems to be the case.  We further noted that based on these factors; there wasn’t a good case for continued strong stock performance this year.  What is currently unfolding is consistent with that hypothesis. 

The Dow Jones Industrial Average has had a rougher start to the year than the S&P 500, declining 7.26% vs. 5.75%.  These percentages are still not large enough to qualify as a market “correction” (defined as a 10% decline), but they’re not that far off and will likely get there in our opinion. So if we saw this coming why, not sell and lock in our profits?  The simple answer is that we feel that this is a short-term situation and still believe we’ll end the year modestly higher.  In the meantime, there isn’t a good investment alternative. 

If interest rates drift higher this year, as we expect, anything but the shortest maturity bonds will see declines in their values.  The yields on very short-term bonds are barely 1%, which means in real terms, you’re losing money.  Conversely, our equity cash flows are still in the 2% range.  Thus, we’re getting better income by remaining invested and riding this stock market volatility out.

The month of December has always had the largest dividend payouts of the year.  Thus, we’ve recently accumulated larger than normal cash reserves in most of our client portfolios.  We aren’t necessarily viewing this as a great buying opportunity, but are taking this selloff as a chance to put some of our cash back into the market.  If stocks do finish 2014 at least flat, the returns on our most recent equity purchases should return north of 9% for the year.  Until then, don’t be surprised to see the Dow drop below 15,000. 

Keeping the Pedal to the Metal

We’d been saying all through 2012 and 2013 that we felt as long as the Federal Reserve kept printing money by the tens of billions every month, stocks would continue to rise. All we can say is that when you’re right, you’re right; although we must admit that even we’ve been surprised by the kind of numbers posted by all the major stock indices in 2013.

 

Based on the underlying conditions in the economy, though, it’s not obvious that these gains in the stock market are justified. Unemployment is still persistently high, GDP has been stuck in neutral for several years and businesses are very skeptical of the political environment. So why is it that the stock market seems to be telling a much rosier story? As we’ve written many times, the answer is found in Fed policies – i.e. QE1, QE2, QE3 and Operation Twist.

 

These policies have now swollen the Fed’s balance sheet (their portfolio of bonds they’ve been buying) to over $4 trillion. In addition, much of the money that they’ve created to make these purchases is now sitting in bank accounts at the Fed as “excess reserves”. Banks are required to keep a certain percentage of their deposits and capital on hand. These reserves are in the form of cash in their vault to manage their day to day customer transactions and at their account at the Fed used for such things as check clearing. Any amount that they hold above their statutory limit is called an excess reserve. Historically, those excess reserves have been near zero. Today total excess reserves stand just over $2 trillion. 

 

Traditionally when a bank would find itself with excess reserves, they would lend them to another bank that needed them – typically to make commercial loans. The Fed sets the rate that the banks can charge each other (Fed Funds rate). Regardless of what that rate was, it was better than zero, which is what they’d get leaving them as reserves. In 2008 this relationship changed. The Fed Funds rate was basically set to zero and the Federal Reserve started paying banks interest on their excess reserves.

 

This has created the unprecedented situation where it is more profitable for banks to sit on their reserves and not lend to each other. This is why we’ve not seen an increase in inflation even though the Fed has increased the money supply by trillions of dollars. Those dollars are stuck in accounts at the Fed.

 

Throughout the recovery, government officials have been critical of the banking sector for not doing enough to stimulate growth by making loans. But here we are with this perverse policy that runs contrary to the publicly stated goals of the government. So what’s going on? The real policy objective here is twofold. First, the Fed wants to drive all interest rates down to make debt more affordable for everyone. Secondly, they need to finance unprecedented levels of deficit spending.

 

Both of these objectives have been met but now the government needs to find a way out as the accumulated balances reach unmanageable levels. Policy makers announced in December that they would begin the process of winding down these programs. The first such change was to reduce their bond buying from $85 billion per month to $75 billion per month – a mere drop in the bucket. It’s expected that they will announce a further reduction to $65 billion per month in January.

 

The pace of this exit strategy will be crucial to both stock performance and investment yields in 2014. The San Francisco Fed President was quoted as saying that the Fed will likely continue on a path of gradual, measured reductions in bond purchases assuming the economy tracks modest improvements. That is likely to mean $10 billion steps until they are out of the bond buying business. That being said, the Fed is likely to keep paying interest on excess bank reserves and maintaining a near zero Fed Funds rate.

 

Assuming a best case scenario where the Fed’s exit strategy unfolds as planned, investors will face many challenges. Through all the QE programs, the Fed has created a significant bubble in the bond market. It’s hard to say where rates should be without the government’s interventions but longer term bonds are likely going to get hit hard through this process. So looking to higher yields in this market is a fool’s game until rates eventually find their natural levels. Who knows how long that will take? It could be two or more years.

 

With the Fed still firmly in control of short-term rates, it’s unlikely we’ll see any meaningful yields on short-term bonds over the next couple of years. Once you factor in inflation, those returns could even be negative in real terms.

 

While neither of these events is new for the bond market, investors have found solace in the stock market. Double digit returns have made up for the lack of yield in bonds and given investors a sense of progress. Looking towards 2014 and 2015, questions remain on how stocks will fare without the government’s support. Earnings and valuations are called into question in the face of higher rates.

 

Corporate earnings are already beginning to trickle in and they aren’t great. Investors are wondering if soft earnings will justify more stock gains. If interest rates negatively affect GDP, earnings will come under even more pressure. By a variety of measures, stocks are already pretty expensive. The S&P 500 currently trades at about 16 times earnings which is already above the recent historical average of 13.

 

We see little reason for stock prices to continue their previous two year gains into 2014. Historically, when stocks reach their tops, trading gets choppy. We think that will be the case this year. But when all is said and done, our guess is that we’ll finish the 2014 with single digit returns. Half of that will probably be in the form of dividends.

 

Our best case for support this year in the stock market is the fact that there still remains nowhere else to go. That’s not much in the way of confidence but it is the reality. The Fed is still going to run the show until the QE’s end and they successfully unwind a substantial part of their $4 trillion portfolio.