Market Commentary - April 2012
Posted on Monday, April 16, 2012
Stocks: Best First Quarter Since 1998
R. Kevin O'Keefe, CIMA®, AIF® | Chief Investment Officer
Despite ongoing global economic unease, rising oil prices, and continuing housing market worries, the first calendar quarter of 2012 was very good to investors.
In Europe, sovereign debt issues stabilized (at least temporarily). U.S. economic indicators improved generally, but perhaps most important, the unemployment rate fell.
The S&P 500 Index gained 12.6%, while the NASDAQ Composite posted its strongest Q1 return since 1991, adding a whopping 18.7%. International stocks were not far behind the U.S., with the MSCI EAFE Index advancing almost 11% in the first quarter, recouping much of its 12% loss in 2011.
Returns from bonds were much smaller. The most popular category of bond funds-funds holding intermediate-term, investment-grade bonds-returned an average of 1.5% during the first quarter, according to Lipper Inc.
Many Still Avoiding Stocks
The impressive rally notwithstanding, stock funds continued to experience more outflows than inflows of investor capital.
Lipper's preliminary fund flows reports show that stock mutual fund investors continued to redeem shares during the first quarter. Net withdrawals from equity fund assets were an estimated $1.7 billion from the conventional funds business, excluding exchange-traded funds (ETFs).
It isn't that investors needed the cash. They continued to pour money into bond funds, injecting some $75.8 billion into taxable fixed income funds and a net $13.6 billion into muni bond funds during the first three months of 2012.
Expressed another way, for every dollar that investors sold out of stock funds, they bought more than $50 worth of bond fund shares.
This concerns us because bonds are relatively unattractive compared to stocks.
Investors who have been paying the least bit of attention in recent years know full well how volatile the stock market can be. Stocks continue to offer attractive long-term profit potential for patient investors, but the ride along the way is anything but smooth. Historically, bonds provide an important service in dampening portfolio volatility.
We can appreciate that investors would want to avoid exposure to a stock market plunge, but the unprecedented appetite for bonds among investors today, despite historically low interest rates, indicates to us irrational behavior on a massive scale.
Why Invest in Bonds?
There are two reasons to invest in bonds:
For current income; and
To reduce portfolio volatility, because stocks and bonds are not usually highly correlated.
With regard to current income, investors should understand that short-term investment-grade bonds produce hardly any income any more. In order to generate income from bonds equal to the dividend income from a diversified stock portfolio, you have to either invest in intermediate- or long-term bonds or below-investment-grade bonds, or both.
It may not be unreasonable to include some intermediate- and long-term bonds, and maybe some high-yield corporate bonds, in your portfolio; however, as bonds with longer maturities are purchased to capture a little extra yield, more risk is injected into the investment strategy.
The same is true of credit risk. High yield bonds do not behave like AAA-rated bonds. In extreme stock market conditions, high-yield bonds behave more like stocks than bonds.
Investors need to understand this, and not be lured into investing in high yield fixed income because of the juicy yields available. Those fat yields carry a big price tag: risk. There is no "free lunch" on Wall Street. Where bonds are concerned, there is a high correlation between current yield and the market's perception of risk.
We believe that including a small allocation to high-yield bonds in some of our portfolios makes sense, depending on the overall bond allocation. And intermediate-term bonds certainly offer more income than short-term bonds. But we strongly caution investors against overreaching for yield by reducing credit quality or extending maturities. It's like jumping in front of a moving steamroller to pick up a few pennies-it doesn't look risky, and it's 'free money' after all-until your shoelace gets caught under the roller.
When Will Interest Rates Rise?
We believe we are nearing the end of a thirty-year bull market in bonds. Is it reasonable to expect bonds to continue to perform as they have in the past?
One of the most basic concepts about bonds is this: Prices move in the opposite direction of interest rates. And here's an important corollary: The magnitude of the price move depends on the remaining duration-the longer the remaining duration, the more significant the price move.
Rates have stayed low, thanks in large part to the actions and statements of the Fed and Chairman Ben Bernanke. But if the economy gains momentum, interest rates will eventually rise; they have to. And the faster they rise and the higher they go, the farther bond prices will fall (longer-term maturities falling farther than shorter-term maturities).
Fixed income investments will continue to reduce portfolio volatility, but bonds-particularly longer-term bonds-can be expected to produce their own volatility. So it is now more important than ever to manage the volatility of a bond portfolio.
The technical aspects of bond investing are not simple, and an in-depth discussion is beyond the scope and purpose of this Market Commentary. But when investors are selling stocks at a time when corporate profits are hitting record highs, and rushing into bonds when yields are at record lows, we have to scratch our head. Why would investors behave this way? Do they think bonds will continue to perform as they have since 1981? Are they trying to squeeze the last little rallies they can from bonds before the tide goes out? Do they think that medium and long term rates will drop below 1%? Or, have they simply not given it much thought?
Rear-View Mirror Investing
A possible explanation for irrational behavior is "rear-view mirror investing"-assuming that simply because an asset class has performed well (or poorly) for a long time, it will likely continue to perform pretty much as it has.
Many trends do persist, and some for a very long time. House prices nationally rose every year since World War II, until the bubble burst in 2008. We cannot predict when the 30-year+ bull market in bonds will end, but we are pretty confident that in a mildly reflating world, it will end.
No Need for Despair
To be clear: We are not issuing a sell signal for bonds. Portfolios still need diversification among asset classes, and an appropriate selection of bonds makes sense for virtually everyone. The volatility of an all-equity portfolio is simply too great for most investors.
What we are saying is that the phenomenon we have been observing, in which investors have been selling stocks and buying bonds like there's no tomorrow, is irrational. While we might understand the reasons so many investors are doing this, these reasons are not very sound, and the behavior is likely to cause more harm than good in the next several years. As a result, we continue to counsel our readers to maintain investment discipline.
It's natural to fall back on things that have worked well in the past. Clearly, bonds have had a good long run. But their attractiveness from a forward-looking perspective is fading, compared to stocks. To repeat: Bonds still have a place in portfolios; but with yields where they are, we are cautious.
If it has been awhile since you have reviewed your Investment Policy Statement with your advisor, let us offer a gentle nudge that you put this task on your to-do list this quarter or next. But the clock is ticking. Can you hear it?
Kevin O'Keefe, Managing Member and Chief Investment Officer of First Affirmative Financial Network, LLC, is responsible for due diligence and monitoring of mutual funds and separate account managers.
Market Return Assumptions and Expectations
R. Kevin O'Keefe, CIMA®, AIF® | Chief Investment Officer
Long-time readers may be familiar with my views about the usefulness of market forecasting. Essentially, I consider fortune-tellers to be at least as accurate as stock market pundits, and I apologize to fortune-tellers for the comparison.
There is a difference, though, between stock market forecasting and developing assumptions and expectations concerning asset class returns. The latter is actually a necessary part of longer-term financial planning. Near-term prognostications may be worthless, but without assumptions and expectations of longer-term attractive investment returns, why would anyone invest? Why accept the tremendous uncertainty if there were no expectation of worthwhile gains?
The Investment Policy Statement ("IPS") is integral to an investment strategy. Every investor should have an IPS, and it should be reviewed at least annually and updated as necessary. An IPS typically includes information about the expected returns or assumed returns either at the asset-class level or at the portfolio level; an expected return is assigned to each asset class, and then the portfolio's expected return is calculated based on its asset allocation.
No one should expect a portfolio to actually produce a return equal to its expected return over any time horizon. For this reason, a "range of returns" expectation is often preferred because this dispels the notion that any specific rate of return will actually manifest. In any case, it is useful for the investor and the advisor to check in with each other periodically to ensure that their expectations are in synch.
Although the long-term performance history of stocks, bonds, and other assets is useful in developing return expectations, a sound process goes beyond simply assuming that "past is prologue." In what important ways are conditions which affect capital investments today different from various periods in the past?
New Frontier Advisors, a firm that specializes in portfolio optimization techniques utilizing their own proprietary methodology, has been providing their analysis of asset class return estimates each year to fi360, Inc. fi360 has been promoting a culture of fiduciary responsibility and with whom First Affirmative has enjoyed a decade-long strategic relationship.
In their February 2012 update, New Frontier examined the data they consider to be most relevant in estimating asset class returns: historical return data; return premiums (historical data compared to inflation or short-term interest rates); recent returns, current yields, current and forecasted CPI; and beta relationships.
Their summary indicates return estimates of about 8 to 8.5% annualized for U.S. stocks, and slightly higher for international stocks. Returns from bonds are estimated at about 3.5 to 4.5%, depending on credit quality and maturities.
These figures are consistent with estimates we have heard and read from other parties with different methodologies, as well as with our own sense of what is reasonable and prudent. Remember, past performance is no guarantee of future results.
To reiterate, return estimates are useful for planning and monitoring purposes. If it has been awhile, we recommend that you check your financial plan and/or IPS to see what the return estimates are. If your documents are a decade old, there's a good chance the estimates are considerably higher than the current estimates, and your plan should be updated.
As ever, you should consult your trusted advisor. S/he can help you reach your financial destinations without experiencing too much discomfort along the way.
NOTE: Mention of specific companies or securities should not be considered a recommendation to either buy or sell that security. For information regarding the suitability of any security for your investment portfolio please contact your financial advisor. Past performance is no guarantee of future results.
First Affirmative supports a nationwide network of investment professionals (Find An Advisor) who work with socially conscious investors and produces the premier annual industry conference. The 23rd annual SRI Conference on Sustainable, Responsible, Impact Investing will be October 2-4, 2012 at the Mohegan Sun Conference Center in southeastern Connecticut (www.SRIconference.com).