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.