The stock market proved an old adage last month as investors reacted negatively to Fed Chairman Ben Bernanke’s recent comments regarding the central bank’s monetary policy in response to an improving economy. Go figure - the economy is finally showing signs of life and investors sell.
Bernanke indicated the Fed may start to ease up on the Quantitative Easing gas pedal that has been fueling the economy and outlined a time frame for tapering off its $85 billion monthly purchases of mortgages and bonds. However, he said they will not “hit the brakes” by terminating bond buying and start raising rates until several conditions are met, including unemployment below 6.5%, stable financial conditions and inflation expectations above 2.5%. Investors took this as a cue that it was time to sell now. The S&P 500 promptly fell 5% and interest rates rose to levels not seen in over a year. So much for the Fed’s goal of increased transparency!
The effects of the Fed’s stimulus programs are gaining traction, most evident in the housing industry. Home sales and prices have bounced nicely off recent lows as higher mortgage rates are creating a sense of urgency among buyers. Also, sellers, who have been unwilling or unable to shed their underwater homes, are now putting those properties back on the market. The rise in rates isn’t due as much to increasing loan demand, but instead to downward pressure on bonds from investors selling. The fear of higher interest rates becomes a self-fulfilling prophecy as investors sell bonds causing interest rates to rise.
The second quarter of 2013 produced a wide range of equity returns. Even after the June sell-off, domestic stocks fared moderately well, led by small-cap (S&P 600) companies, +3.92%. It was another story for international stocks as a slowdown in China and other emerging countries resulted in losses of -7.88% for the Emerging Markets Index (EM) and a -1% loss for the more developed Europe, Australasia and Far East Index. Year-to-date, returns ranged from +16.19% (S&P 600) to -9.57% (EM).
Financial pundits are lamenting those poor souls who own bonds in their portfolios. Since we know few investors that can tolerate the volatility of an all-stock portfolio, we include bonds in our clients’ accounts to temper that volatility, produce modest income and provide primary liquidity. Bonds are the seatbelt that keep investors committed to their long-term plans. However, our fixed-income strategy is (and will remain for the foreseeable future) to invest in a short-term laddered portfolio with a net spread over U.S. Treasuries. This structure welcomes a rise in interest rates.
As expected, fixed-income returns were in the red for 2Q-13 since bond prices fall when interest rates rise. Our benchmark, the short duration Barclays Capital 1-5 Year Government/Credit Index, experienced modest losses of -0.75% for the period and -0.48% for the first half of 2013. This compares with much greater damage for longer duration holdings such as the -6.10% and -7.97% losses suffered by the Barclays U.S. Long-Term Government/Credit Index during 2Q-13 and 1H-13, respectively. As bad as the bond market was it pales in comparison to precious metals. Gold and silver dropped -25.42% and -34.15%, respectively, during the quarter and -28.37% and -37.03% over the past 6 months. Doomsayers expecting the sky to fall got crushed under the weight of their own fearful bets.
Investors reacting to comments from Ben Bernanke or to predictions of global financial catastrophe are missing the point. Successful investing requires a sound financial plan (monitored and updated through time), which is funded by a low-cost, prudently diversified and periodically rebalanced portfolio. It also helps to have a partner that truly understands this and is committed to your success.