3rd Quarter 2015 Commentary

Volatility is King 
 So where do we begin?  The third quarter of 2015 was undoubtedly one that we all would like to forget.  In fact, we’ve fielded a lot of questions by anxious clients over the previous weeks wondering how we see the markets and the economy in the near future. Those are challenging questions to answer.  Investments of all types have struggled lately and the traditional safe-haven asset classes haven’t proven to be effective either.  In real terms, even cash is losing around 1.5% a year as evidenced by the fact that the Treasury has issued over a trillion dollars’ worth of one and three month Bills at an interest rate of 0%.

The depth of the quarter’s decline was very broad as the following table shows.  As bad as these numbers appear, they don’t even show the worst of it.  The S&P 500 was off as much as 11.4% near the end of August.  The other indices were down similarly around that time.  Alternative asset classes such as commodities suffered even worse losses.  The Dow Jones commodity index lost 12.7% for the quarter.  

These are very strange times and people are concerned that we’ll have another selloff like we saw in 2008.  While the general trend in the quarter has been sharply lower, it hasn’t been all down. Instead it’s been a whipsaw.  One day the news is perceived as highly discouraging and the next it’s not so bad.  This has led to massive money flows in and out of various asset classes and thus the seemingly endless triple digit swings in the Dow Industrial Average. 

The theme damaging to both the stock and bond markets (here and abroad) is uncertainty.  As of now, we have a number of major issues causing this heightened sense of uncertainty.  The market is uncertain as to when and if the Federal Reserve will start the process of interest rate normalization and begin raising interest rates in the future.   There is uncertainty given the economic slowdown in China which caused their stock market to swing wildly and eventually spilled over to stock markets around the globe. The collapsing oil and commodity prices is another sore spot and is a source of major uncertainty. 

The volatility has continued into this month (thankfully to the upside).  As of this writing, the Dow Industrial Average is down only 3.4%.  Our expectation remains that stocks will generally finish flat or with modest gains this year.  The fourth quarter is usually a pretty good quarter for stocks.  Since the early 1990s, the broad U.S. stock market, as measured by the Standard & Poor's 500 index, has declined in value in the fourth quarter only two times. The average gain in the 13 instances where stocks have risen in the final three months of the year is 6.3%.  If something similar holds true this year, the market would finish up about 1%.  With dividends, the total return would be around 3% - right in line with our expectations.

The Pursuit of Income is Sometimes a Bumpy Road
 In 2008, the S&P 500 lost over a third of its value.  It wasn’t until sometime in 2012 that the market fully recovered.  Stocks traded in 2009 at values similar to the height of the dot-com days at the end of 1999.  These are long periods of time that stocks essentially had zero return.  But inside of those periods, a lot of gains could actually be had.  To be a successful investor, you have to be able to buy and sell when it’s right for you, as opposed to something or someone else dictating when you make those trades.  Those outside forces could be anything from a margin call to needing to raise cash to pay your bills.  This is one reason income is so important to investors’ total return. 

Income gives you the predictability and liquidity that allows you to ride out bad markets.  This couldn’t be any truer than for retirees.  Also, having the ability to rebalance in good times and bad is key to taking advantage of wild market moves.  Portfolio income can keep you from having to sell into a bad market or build up and give you the liquidity to buy into one of these selloffs.  We actually used the sharp decline earlier this quarter to increase our equity holdings.  The funds we used were largely cash from interest and dividends that had built up. To generate this income, we have typically used high credit corporate, municipal and agency bonds for our fixed income allocations. But those are not an option at this time due to the extremely low yields in those markets.  In 2007, we could easily have bought “A” rated or higher corporate or agency bonds yielding around 7%.  Those bonds today would yield less than 2%.  It been this way for many years now and the ones we have owned are now paying off.  This has forced us, and all traditional bond investors, to look to alternative sources for income. 

We now hold a wide array of income producing securities in large percentages relative to our usual bond allocations. Examples would include high yield bonds, preferred stocks, MLPs, closed end funds, and bank loan funds.  These alternative income producing securities behave very differently from traditional bonds. Adding these alternatives to our portfolios have allowed us to keep up with our income requirements, but it has come at the cost of price volatility. 

In more normal times you’d hardly see any change in value in the fixed income portion of your portfolio from month to month.  That has not been the case lately as the prices for these alternatives have been affected by the same forces driving the stock market. This is especially true for high yield bonds and MLPs.  While we don’t like to see price pressure on these securities, the trade-off has been, and will continue to be, much higher income.  Our goal is to slowly work our way out of these positions and back into bonds but we have to wait until bond yields improve dramatically from here.  That could be years.  When all is said and done, though, we expect to sell these at prices around where we bought them and simply have our holding period return be based on the cash flow – somewhere around 7%.