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Archive for July 2010

Quarterly Letter – 2nd Quarter 2010

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Quarterly Investment Commentary

Executive Summary

The second quarter of 2010 was volatile.  Stocks are down year-to-date through June.  Domestic bonds were a bright spot.

There is an economic tug-of-war being waged in the markets.  On one side, economic indicators and company fundamentals are improving.  On the other, concerns remain about household and government debt and long-term economic strength.  This has stocks trading in a range, for now. 

Most economists agree that it is not likely that we are heading for a double dip recession.

We face economic challenges going forward.  These include high levels of government debt, an aging population, and a slow and choppy economic recovery.

To be a successful in this climate it will require us to have long-term discipline and patience.  Proper portfolio design can help overcome volatility and find opportunities in difficult markets. 

Changing course during periods of financial distress is generally not a good idea, but this is exactly what average investors tend to do.  This is why they dramatically underperform the market

Full Commentary

The equity market roller coaster returned in the second quarter.  Stocks were down in June, ending the first half of 2010 with losses across all equity markets. Year-to-date through the end of June, the S&P 500 was down 6.65% and the Vanguard Total International Stock Index was down 12%.  That being said, the stock market rallied sharply in the first two weeks of July.

As for the bond market, there was better news.  The Vanguard Total Bond Market Index Fund was up 5.3% year-to-date through June. Foreign bonds were mixed.

Meanwhile, government spending has jolted the economy back to life, but at a longer-term cost to the budget deficit. Further, entitlement spending (for Medicare and Social Security in particular) is projected to grow substantially in the years and decades ahead. The deficit will be difficult to fix without damaging a fragile economic recovery.

 The Economic Tug-of-War and Double Dips

 Recent volatility reflects the economic tug of war being waged in the markets.  On one side, economic indicators and company fundamentals are steadily improving.  On the other, concerns remain about household and government debt and the longer-term strength of the economic recovery.  The tension between these opposing forces has left the market uncertain about the future and stuck in a trading range, for now.

Looking at it another way, the leading economic indicators are rolling over, that is, they are no longer experiencing sharp gains and some of them have turned negative.  Consider the chart on the following page.

According to Charles Schwab’s Chief Investment Strategist, Liz Ann Sonders, the rolling over phenomena occurs when the economy shifts gears from recovery to sustained growth (see the exits from previous recessions marked in green below).  That transition is not always smooth.  Sonders believes that the recent pull back is typical after a powerful bull market recovery.  She does not believe we are heading for a double-dip recession, but rather a soft patch followed by a long, bumpy ride towards eventual expansion. 

 

 To be sure, many economists doubt that a double-dip recession is in store. One reason may be that we have just had three solid quarters of real growth in the gross domestic product. According to Yale economist Robert Schiller, when inflation-adjusted GDP has come out of a decline and posted three or four quarters of gains, it has never immediately begun to fall again — at least not since quarterly numbers began to be issued in 1947.

Unprecedented Volatility

Consider the recent swings in the S&P 500:

October 12, 2007, to March 6, 2009 (down 56%).

March 6, 2009, to April 23, 2010 (up 78%).

April 23, 2010, to June 30, 2010 (down 15%).

June 30, 2010, to July 14, 2010 (up 5%).

The amount of volatility in the stock market is truly remarkable.  As investors, it drives us crazy.  So, what do we do about volatility?  Please keep reading.

The Challenges We Face

Household and Government Debt

As you already know, there is too much debt in most of the developed world (the US, Europe and Japan, specifically), both at the household and government level.  The process of deleveraging (i.e. paying of those debts) takes a long time. 

 At the household level, the deleveraging process will keep a lid on consumer spending.  It will take another couple of years to work through all the foreclosures, thus hampering the residential real estate recovery.  The good news is that personal savings rates are on the rise for the first time in decades.

At the government level, the developed world must walk a tightrope as it deals with the pressing need to slow and ultimately reverse debt growth without also seriously harming economic growth rates.  Too much austerity too soon risks smothering an already fragile recovery.  But waiting too long to tackle rising debt levels digs a deeper hole and risks a lenders’ strike, which could result in government borrowers (and all others too) being forced to pay a much higher interest rate to finance their debt. 

 The Baby Boomers

 Whether we like it or not, baby boomers (including myself) are getting older.  We are starting to retire, and this presents several challenges. Savings rates will face downward pressure as more of the population moves from working and saving to retiring and depleting savings, and paying fewer taxes. More retirees also mean higher Social Security and Medicare expenses.  We will be fighting these headwinds for the foreseeable future.

A Slow Recovery

While the private sector gradually delevers, and we wait for the public sector to do the same, there is no denying that the US is experiencing an economic recovery, albeit a tepid one. There has been clear improvement from the depths of the recession. The economic cycle is, for now, a plus, but the big problems have not been resolved.

Three variables critical to improvement in private-sector consumption and a normal recovery—the labor markets, credit growth, and housing—remain weak. We are still down about eight million jobs from the peak and private sector job growth is barely positive – though that is an improvement from last year. Credit markets remain tight. And the housing outlook, which is critical to household financial strength and the banking sector, remains cloudy and appears to be slipping backward with an expiration of the homebuyer tax credit.

That being said, there are positives signs. The continued impact of massive federal stimulus (though this will wane later this year in the US), healthy corporate balance sheets and cash flow (after huge cuts to expenses), and a natural rebound in economic activity after a huge decline are also sources of strength in the US and global economy.

Europe and Japan face larger hills to climb.  Europe is experiencing very slow growth, southern Europe is uncompetitive and experiencing a sovereign debt crisis.  European economic policy is a challenge given a single monetary policy , but no political union.   Japan is even more demographically challenged than we are.

The emerging economies appear to be the bright spot.  They are in much better shape with stronger balance sheets, higher growth rates, younger populations, and slowly emerging consumer sectors. Their strength is an important source of support for the global recovery.

Thus, the recovery continues, but it is a slow and choppy one.

Investment Posture

Stocks

Investing in stocks requires long-term discipline and patience, especially now.  Is the risk of stocks still worth it in the long-run?  I ask myself this question almost every day, but my answer continues to remain, yes.  I believe that stocks still provide an important source of long-term growth in most portfolios, but only for a portion of your portfolio and when you have at least a five-year investment horizon.  My current allocation in equities (US, foreign, emerging, and private) ranges from 20% (for conservative portfolios) to 60% (for aggressive ones).  That being said, I routinely see portfolios with 80% or more invested in stocks, and many of those investors are within 10 years of retirement.  I believe that is too risky.  

Bonds

Bonds are not providing very high yields these days, but they have provided a steady source of return while the stock market remains volatile.  Since current interest rates cannot move much lower (and will probably be heading higher sometime in the future), it is important to focus on high quality and short duration fixed income investments.  Those investments will fare better in a rising interest rate environment.  I also believe there are opportunities in emerging markets local-currency bonds, albeit with higher volatility.  Finally, I believe that bond fund managers with the flexible mandates and the right expertise will continue to find good opportunities going forward.

Alternative Investments

Alternative investments that contain true, conservative hedging strategies still provide an opportunity to reduce portfolio volatility, especially if they are not correlated with the equity markets.  Interestingly, some strategies that were only available in expensive and illiquid private hedge funds are now available in public mutual funds with daily liquidity and improved transparency.  I believe that a mix of these strategies is helpful to manage volatility, but only to an extent.  Caution must be exercised here.  Alternative investments can be expensive, lack traditional transparency, illiquid (if they are private), difficult to understand, and rely heavily on volatile derivatives, options, and leverage strategies.

Perspective (and hopefully some wisdom)

 Although we hate to admit it, history does provide the best perspective.  We ignore history because somehow “this time is different,” but in reality, our country and our economy has experienced and survived repeated shocks, recessions (and one depression), terrorist attacks, and setbacks.  And in the midst of those events, we have managed to grow and thrive.

Thinking back to the severe recession in the early 1970’s, we were in the middle of the Arab oil embargo; there was high inflation and unemployment.  We were going to run out of oil in 20 years.  At the beginning of 1975, the S&P 500 stood at 68 (we are now at about 1075 as I write).  There was a lot of doomsday thinking.  In 1979, there was an infamous article that appeared in Business Week entitled the “The Death of Equities,” basically arguing that the previous 10 years of poor performance in the stock market meant that equity investing was over (sound familiar?).  Obviously, the article was wrong.  I also remember the budget deficits of the early 80’s and how our grandchildren and their children would be burdened forever with our government debt, only to see our deficit position strengthen substantially only 10 years later, long before those indebted great grandchildren were even born. 

Are the doomsday prognosticators of today also wrong?  Only time will tell, but history says that doomsday is not a likely scenario.

The best path forward is to stick to fundamentals.  We should revisit our investment philosophy and asset allocations.  We made these plans when our minds were clear and our goals in focus.  These plans provide us with discipline and focus when the path forward is unclear, or when we became anxious or euphoric. 

In the world of investment management, changing course in a crisis is generally not a good idea.  Back in the depths of the latest crisis, I rebalanced client portfolios by buying equities and resisting the temptation to run for the hills.  Of course, this was not easy, but it was the right thing to do.  And this strategy was validated as those portfolios have recovered.  Those that ran for the hills remain there – their portfolios unrecovered.

If there were ever a reason to remain steady in times of financial stress, consider the following study.

According to Morningstar, over the 20 years ending December 2008, the S&P 500 index averaged a gain of 8.4% a year. The average equity fund investor, however, gained only 1.9% a year over that time frame. Equity investors also underperformed over the prior three and five years.

For fixed income investors, the results were similar as the Barclays Capital US Aggregate Bond Index gained 7.4% a year for the past 20 years while the average fixed-income fund investor gained only 0.8% a year. Bond investors also underperformed the bond index over the prior three and five years.

Why?  It is because the average investor does not have an investment philosophy, let alone an asset allocation.  They jump into the market when it feels right (usually the peak of a cycle) and out of the market when things feel bad (usually the bottom of the cycle).  They change course frequently and usually at just the wrong times.  They follow their gut.  They chase returns.

 To avoid these mistakes, let’s stick to our asset allocations, rebalancing at the peaks and troughs.  If the facts dictate that a change to our investment philosophy is truly in order, that’s fine, consider the options.  But when “facts” only serve as a mask for our fear and anxiety, we should not be misled into changing course.

As always, I welcome questions about your individual situation.

Austin Lewis, JD, MBA, CFP

Lewis Wealth Management, LLC

26 W. Dry Creek Circle, Suite 510

Littleton, Colorado 80120

(303) 500-0980

austin@lewiswm.com

Sources of Information:  Advisor Intelligence, Charles Schwab, and Morningstar.

Written by Lewis Wealth Management

July 19, 2010 at 4:15 pm

Posted in Uncategorized