Investment Commentary - 2nd Quarter 2012

Stock investments roared into 2012 with the S&P 500 closing the first quarter up 12.59%. International markets also posted strong quarterly returns as investors seemed to feel that Greece compromises helped to avoid a chaotic default and seemed to buy some breathing room. The quarter was also notable for muted volatility in equities. While stocks zoomed, bonds stalled and their returns were relatively unchanged.

Source: Morningstar Direct

Economic data seems to be disappointing bulls and bears alike. Pessimists are predicting recession, but leading indicators continue to suggest that things are getting better. Those more naturally optimistic are looking for better employment numbers and decisive growth. We break down unemployment trends here. For now, we think it’s best to be constructive and cautiously optimistic.

The exceptionally strong market returns of the last six months may mean that it’s time for a breather, or (in market speak) consolidation. Longer term, balance sheets and stock earnings continue to indicate corporate health. Another indicator, University of Michigan Consumer Sentiment, shows recovery off of depressed lows over the summer, but is below the 30-year average. Keep in mind that stock dividends are rivaling Treasury bond yields and we are comfortable maintaining neutral allocations to stocks.

As the saying goes, “Don’t fight the Fed” and Operation Twist coupled with European Central Bank liquidity injections seem to be helping to support modest growth. On April 11^th, Vice Chairman of the Fed, Janet Yellen, indicated that low rates could extend beyond 2014 if the pace of growth fails to accelerate. For more on the impact of recent Quantitative Easing on stocks, click here.

The lackadaisical recovery and Fed accommodation may be buying time for bondholders as the Fed works to keep interest rates low. Data shows that investors have continued throwing money into bonds in spite of the threat of rising interest rates. This may be good news for stocks as strong returns were not driven by investors “crowding in”. Conversely, the nearly insatiable public demand for bonds gives us pause. Those relishing the relative comfort that bond investments have offered in the past thirty years may want to reconsider future assumptions. Learn more about our concerns in bond markets and how we’re investing here.

We’ve just completed a blog series that discusses components of our investment process that you might find helpful.

Introduction: The Investor’s Chief Problem
Strategic Allocation: Building Your Foundation
Tactical Allocation: Deck the Halls with Tactical Allocation
Types of Investments: Time to Declutter
Buy Process: Salad Surprise
Sell Discipline: The Gambler
Rebalancing: Game Plan

If you have topics you would like us to cover in the future, please let us know! As always, we appreciate the opportunity to meet your financial planning and investment needs. Thank you!

Sincerely,

Melissa Joy, CFS
Partner & Director of Investments
Financial Associate, RJFS

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The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Any opinions are those of Melissa Joy and not necessarily those of RJFS or Raymond James. Expressions of opinion are as of this date and are subject to change without notice. This information is not intended as a solicitation or an offer to buy or sell any security referred to herein. Investments mentioned may not be suitable for all investors. Past performance may not be indicative of future results. Please note that international investing involves special risks, including currency fluctuations, different financial accounting standards, and possible political and economic volatility. U.S. government bonds and Treasury bills are guaranteed by the U.S. government and, if held to maturity, offer a fixed rate of return and guaranteed principal value. There is an inverse relationship between interest rate movements and bond prices. Generally, when interest rates rise, bond prices fall and when interest rates fall, bond prices generally rise. All indexes are unmanaged and an individual cannot invest directly in an index. Index returns do not include fees or expenses. Dividends are not guaranteed and must be authorized by the company’s board of directors.

US Stocks & the Federal Reserve - 2nd Quarter 2012

As the saying goes, “Don’t fight the Fed!” Many investment experts have noted the strong relationship between the market’s ups and downs and Federal Reserve policy. This chart, compiled by Doug Short at dshort.com beautifully illustrates the relationship between Fed intervention programs and the S&P 500. 

While Operation Twist is scheduled to end in June 2012, Federal Reserve board members have also started to use stated future targets for interest rates as a means to encourage market participants to invest in stocks. As recently as April 11^th, Fed Vice Chair Janet Yellen indicated that the Fed’s “Zero Interest Rate Policy” could remain even past the initial 2014 target date. If markets stumble, some think that a third round of Quantitative Easing may also be possible.

There will come a time when markets need to stand on their own two feet. Based upon the words and deeds of the Fed, those days may be several years away.

Hat Tip: The Big Picture, Barry Ritholtz.

Unemployment Trends - 2nd Quarter 2012

Unemployment has been slowly falling over the past year, despite what you might be hearing from naysayers, and currently stands at 8.3% nationally according to the U.S Bureau of Labor Statistics.  Because of the severity of the recession we suffered in 2008 and 2009 unemployment has recovered much slower than in past recessions.  This has been despite the large amount of liquidity that the Federal Reserve Bank, or the Fed, has pushed into the system.  At this point the Fed has gone about as far as it can go to stimulate job growth.  So what needs to happen next to keep the unemployment trend heading downward?

Part of the problem is the private sector has simply been unwilling to hire so far during the recovery.  They have enjoyed nice productivity gains from their current employees and have not seen the need to hire until recently.  Now, however, productivity growth is slowing and they are realizing that they cannot squeeze anymore blood out of the stone.  But even with all of these job openings, the unemployment rate is not dropping as quickly as it should. 

There has been a “structural” change in the job market meaning that there aren’t enough qualified people available and in the right places to fill specific job openings.  Pairing a worker with a job opening is much the same in principle as a couple’s matchmaking.  You aren’t simply going to marry the first person you date.  Sometimes it can take a very long time to find the “right” person. 

Only a decade ago one could get a good job in the manufacturing industry with little or no higher education required.  Now you can see in the chart below, there has been a large spike in unemployment the less education that you have.

The economy is undergoing a structural change emphasizing the need for retraining in order to go into fields with employment opportunities.

According to the above chart manufacturing jobs are scarcer, employing 40% fewer workers than 12 years ago.  During that same decade, jobs in education and health services, which generally require more education, have grown nearly 20%. 

Retraining our work force and getting them to where the jobs are is what needs to happen over the next few years.  This takes a substantial amount of time and money to complete and is one of the root causes for the slow decline in unemployment.  Many workers leaving the workforce for retraining fall into a nonparticipation category that is not counted as unemployed because they are not actively seeking employment.  Once these people complete their retraining and find a job they are not considered as coming out of the pool of unemployed.  Over time this nonparticipation pool will become smaller but will not contribute to the declining unemployment numbers.

Ultimately, it could take years more before the unemployment rate falls back to its’ pre-recession levels but when it does our workers should be much better positioned for the fields with growing employment opportunities.

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The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. Any opinions are those of Angela Palacios and not necessarily those of RJFS or Raymond James.

Heeding Warnings on Bonds - 2nd Quarter 2012

As an Investment Committee and firm, we have had concerns about the threat of rising interest rates for some time. The growing chorus of concern for future bond returns rose during the quarter including notable discussion from Warren Buffett in his annual Berkshire shareholder letter. 

Over the past 30 years, bonds have been a significant contributor to investor returns. It takes a veteran investor with a long memory to recall the last time that there were sustained negative real returns for bonds. Coming out of the 1970s, inflation was the chief enemy of the Fed and interest rates remained higher than inflation rates. This meant that even those investing in cash alternatives could preserve the purchasing power of their investments.

We all know what’s happened to the rate of return for cash alternatives since 2008. It has been brutal to pay your bank more in fees to hold your money than receiving back as savings interest rates which have been negligible or nonexistent. Since inflation has hovered between two and three percent, your cash alternative has had a negative real rate of return, that is the return of the investment minus inflation.

Our concern today is that this negative real rate will spread from cash alternatives to other bond categories, most notably US government bonds. There are several ways that bond results can hurt investors:

• Rates rise: As interest rates rise, the price of bonds may go lower. This might result in reduced portfolio values on statements.
• Rates stay flat, inflation rises: Interest rates don’t have to rise to experience disappointing bond returns. A hidden threat is that interest rates remain extremely low while inflation rises. If you subtract the high inflation from low returns in bonds, you may end up with a negative real rate of return as mentioned below.
• Economic deterioration: Investors who move away from bonds that are more sensitive to interest rates in favor of credit risk sensitive bonds may be disappointed if slowing economic factors result in lower bond prices for bond diversifiers.

With baby boomers retiring, the bond conundrum really hits home. A historically tried and true source of retirement income may now be a source of risk. As one investor noted, this means portfolios may need to be much more carefully constructed and complex than they were in the past.

Some specific recommendations:

• Asset allocation: Carefully review allocation decisions with your financial planner and make sure that you are invested for the next 30 years and not the last 30 years. This is especially important if you’ve significantly altered your overall allocation in the wake of the market meltdown of 2008.
  
• Diversification: Not all bonds behave the same. Many types of bonds that did not exist in the last great rising rate environment of the 1970s may offer some aid to investors, or be the best option in a lousy lot. Bonds outside of the US should also be considered. Lower volatility alternative asset classes might also be included in the potentially “better than bond category”, although they take careful consideration and analysis. With diversification comes risk and complication, professional advice is recommended.
• Rethink income strategy: Bond coupons are not the only source of income for an investor portfolio. Stocks which pay dividends are one alternate source. Beyond that, we generally prefer a total return view where both appreciation and income can be used for portfolio withdrawals depending on which assets are overweight. This reinforces the buy low and sell high concept.

We have been discussing the threat of rising rates so much, that I feel like a broken record. Someday I will talk about a time when you could get a mortgage at 3.5%. It might sound as crazy to a younger audience as double-digit Certificates of Deposit rates sound today – something that is very difficult, if not impossible, to wrap my head around. Preparing for the shifting reality of bond returns is the highest priority of our investment committee today!

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Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Any opinions are those of Melissa Joy and not necessarily those of RJFS or Raymond James. Expressions of opinion are as of this date and are subject to change without notice. Investments mentioned may not be suitable for all investors. Past performance may not be indicative of future results. There is an inverse relationship between interest rate movements and bond prices. Generally, when interest rates rise, bond prices fall and when interest rates fall, bond prices generally rise. Diversification and asset allocation do not ensure a profit or protect against a loss. Please note that international investing involves special risks, including currency fluctuations, different financial accounting standards, and possible political and economic volatility. Dividends are not guaranteed and must be authorized by the company’s board of directors. Every investor’s situation is unique and you should consider your investment goals, risk tolerance and time horizon before making any investment. Investing involves risk and you may incur a profit or loss regardless of strategy selected.