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2nd Quarter Overview

The 2nd quarter brought increased volatility to US and global markets – particularly bond markets.  Though at times the market seemed to resemble an EKG machine (plenty of up and down movement, but ultimately flat) the major US indices actually came out slightly ahead. While US stocks edged higher for the quarter, international stocks were flat and emerging markets experienced a sharp decline.  Bonds had their worst quarter in 9 years.  Probable tapering of the Federal Reserve’s (the Fed) easy money policy, Asian market woes, and assorted political tribulations have all contributed to the headwinds facing the market, at least for the short term; but we believe the fundamentals behind our economy as a whole continue to slowly grow stronger.  As such, we at Allgen continue our due diligence of analyzing and allocating appropriately, always attempting to mitigate our exposure to risk – alliteration notwithstanding.

2nd Qtr 2013

YTD 2013

S&P 500 Index 2.91% 13.82%
S&P US Small Cap 600 3.08% 15.86%
MSCI EAFE International Index 0.05% 5.19%
MSCI Emerging Market Index -9.14% -10.89%
Aggregate Bond Index -2.32% -2.44%

In our last market commentary we spoke about how the market has overcome many major lingering uncertainties over the past few quarters.  One major uncertainty still exists – “When will the Fed start to taper its Quantitative Easing (Bond Buying)”.  The Fed has recently given some clues on how it plans to gradually decrease its bond buying.  We will discuss the ramifications and what we are doing to manage the risk and generate returns going forward.

Easy Money Policy Winding Down

In the prior two Fed meetings the Chairman, Ben Bernanke, mentioned the possibility of the Federal Open Market Committee (FOMC) gradually reducing its bond buying (aka Quantitative Easing – QE).  While he alluded to the possibility of starting to taper the $85 billion bond purchases per month by the end of this year and ending the bond buying by sometime towards the middle of 2014, Bernanke did leave the door open to increasing it again in the future if the economy stumbled.  Initially markets did not like this news as bonds and stocks dropped.  The first revelation of the Fed’s intentions came on May 22nd which marked a top in the S&P 500 and acceleration in the drop in bond prices (rise in rates).  The Fed reiterated that it was not tightening monetary policy and the target rate should remain close to zero until at least 2015, but they stated that they were going to start slowly taking their foot off the gas pedal.

Will Bond Rates Go Up?

3rd-qtr-commentary-2

It’s important to understand the inverse relationship that bonds rates (yields) have with bond prices – as rates go up bond prices go down and vice versa. During the second quarter the 10-Year US Treasury Yield went up from 1.85% at the beginning of the quarter to 2.49% at the end of the second quarter. As such, the 2nd Quarter Aggregate Bond Index’s total return declined by 2.32%.  This was the worst quarter for bonds since the 2nd quarter of 2004, and in the last 36 years bonds have only had 2 negative years – 1999 and 1994.  So far this year the Aggregate Bond Index is down 2.44% and may lead to the first negative year since 1999.  We, along with many experts, believe that odds favor rates continuing to rise over the long-term; if the economy started to decline, however, investors would be tempted to sell out of stocks and return to bonds thereby driving bonds higher (which has been the pattern over the last 13 years).

The current long-term decline in interest rates has been a trend for over 32 years, this will eventually end and bonds will start a long-term uptrend again.  The chart on the prior page shows interest rates back to 1790.  You will notice the interest rate cycles are extremely long in duration.  The prior two long-term up trends in interest rates (1900-1920 and 1946-1981) lasted 20 and 35 years respectively.  So, if this is a shift to a long term uptrend it could take several years before interest rates become historically ‘high’ and decades before interest rates peak.  But if this is truly a change in the long-term interest rate trend then investors need to be prepared to manage their assets accordingly.st 36 years bonds have only had 2 negative years – 1999 and 1994.  So far this year the Aggregate Bond Index is down 2.44% and may lead to the first negative year since 1999.  We, along with many experts, believe that odds favor rates continuing to rise over the long-term; if the economy started to decline, however, investors would be tempted to sell out of stocks and return to bonds thereby driving bonds higher (which has been the pattern over the last 13 years).

We have been gradually positioning our client’s bond portfolios under the assumption the bond rates are going up by reducing the duration of our bond holdings (Selling bonds with a longer maturity and buying bonds with a shorter maturity) and by selling all of our long-term treasuries.  At the end of 2012 and during the first quarter 2013 we continued to sell bonds that had longer-term maturities (namely our GNMA holdings) and we increased our holdings in high yield bonds which are more market-linked.  We also increased our investments in bond funds that are flexible to move in-and-out of different sectors of bonds depending on interest rates and the economy.  Going forward we will need to look for income investments that tend to do better in rising rate environments like floating rate bonds (Senior Loans) and equities that trend in the same direction as interest rate movements.  In order to protect bond portfolios from further decline and to try to increase returns we will need to increase risk slightly in order to achieve a higher return by becoming more linked to the stock market rather than the bond market.  Understand though, that our investment philosophy states that we manage risk first, this will not change.

What Will Happen to the Stock Market if the Fed Eventually Stops Quantitative Easing?

To answer this question let’s take a look at what happened when the Fed ended QE 1 and QE 2.  Around March of 2010 QE 1 came to an end after which a 16% drop occurred in the S&P 500, then around June of 2011 the end of QE 2 preluded a 19% drop in the S&P 500.  Both declines were met with an announcement of another round of QE which caused the market to turn to the upside.  If history repeats itself we could see a similar drop in reaction to the end of this most recent round of QE.  The tone this time around seems as if the Fed is trying to end this era of QE, but the Fed has gone out of its way to note that if the economic conditions worsen they will reverse course and go back to supporting the market via QE.

It should be noted that although the market may experience some temporary pain with increased volatility from the ending of this massive Fed stimulus and the return to more normal monetary policy it is actually a good thing. An economy that is dependent on the central bank purchasing $85 billion a month in bonds, while pushing interest rates artificially lower, is not sustainable for the long run.  Although we believe the market could decline as the Fed makes this transition back to “normal” market conditions, we believe it would be a long-term positive for the stock market.

Moving Forward

Regardless of what the Fed does we will continue to search for investments and money managers that withstand the test of time.  On the bond side of the portfolio we continue to position our holdings in order to protect capital in anticipation of a long-term upward trend in rates.  Going forward we will continue to adjust for this rate shift by buying floating rate bonds that tend to go up with interest rates and also looking for income investments that tend to do well in rising interest rate environments.  On the stock side we continue to overweight U.S. stocks while slowly adding international and emerging market stocks as their prices become more compelling.  With the current state of the markets and respective economies, it is important that we maintain our discipline of always managing risk while seeking to capitalize on opportunities.

Written by:
Jason Martin, CFP®, CMT, Chief Investment Officer Allgen Financial Services, Inc.;

Paul Roldan, Chief Executive Officer; Chris Damiano, Operation Specialist

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