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 11th, 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.

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!

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.

Hello 2012!

If you extrapolate last year's lessons, diversification could be seen as the biggest threat to a portfolio. Traditional US Large Company Stocks and US Government Bonds sprinted past limping "diversifiers" such as international stocks, non-traditional bonds, and alternative investments. Over history, clients have generally benefited from diversification. But this pillar of investment discipline turned into a headwind last year.

For equity investors, flat domestic returns did not tell the whole story. Consider that the return of the S&P 500 index last year was 2.1% including dividends. US Companies took a roller coaster ride to get back to their starting point - disappointing summer news was eventually overcome by maintained slow growth and exceptional corporate profits.

Source: Morningstar, Inc.

For investors,

staying the course was a challenging proposition last year. The return landscape was even more challenging for portfolios with exposure to international markets. A natural disaster and nuclear situation in Japan first set things on edge followed by enduring concerns about debt which continues to engulf the Eurozone.

Bonds were king in 2011

with long bonds issued by the US government ruling the roost. Key interest rates found new lows (insert hyperlink to interest rate chart from RJ). This was helpful if you were in the position to refinance your mortgage and was also helpful from a portfolio perspective. However, those investors who anticipate a rate rise in the future and have positioned portfolios to attempt to minimize the risks did not fully participate in the boom for fixed income investments.

Our resident economist,

Angela Palacios, CFP ®, notes that unemployment has continued its downward trend since August and is currently at 8.5% nationally which is the lowest level in more than three years according to the United States Department of Labor, Bureau of labor Statistics. Retail, manufacturing, transportation and health care are a few of the sectors enjoying job growth. Based on initial claims so far this month it also looks like we will see another decline in the rate even though it is normally high in the first two months of the year with temporary holiday workers being laid off. This reduction in unemployment is a lagging indicator of the economy showing the pickup in economic growth even though it may be slow.

Short-term lessons don't always help investors focused on the long-term results. We still believe there are critical benefits to diversification and maintain portfolios with a variety of distinctive asset categories and strategies. Our process-driven investment strategy is also designed to avoid performance-chasing sirens in favor of disciplined investing.

Sincerely,

Melissa Joy, CFS

Partner, Director of Investments

Financial Advisor, RJFS

Inclusion of these indexes is for illustrative purposes only. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance. Individual investor's results will vary. Past performance does not guarantee future results. The S&P 500 is an unmanaged index of 500 widely held stocks that's generally considered representative of the U.S. stock market. The Barclays Capital Aggregate Index measures changes in the fixed-rate debt issues rated investment grade or higher by Moody's Investors Service, Standard & Poor's, or Fitch Investor's Service, in that order. The Aggregate Index is comprised of the Government/Corporate, the Mortgage-Backed Securities and the Asset-Backed Securities indices. The Russell 2000 index is an unmanaged index of small cap securities which generally involve greater risks. The Dow Jones Industrial Average (DJIA), commonly known as “The Dow”, is an index representing 30 stock of companies maintained and reviewed by the editors of the Wall Street Journal. Russell 1000: Measures the performance of the 1,000 largest companies in the Russell 3000 Index. MSCI EAFE (Europe, Australasia, Far East): A free-float adjusted market capitalization index that is designed to measure developed market equity performance, excluding the United States and Canada. The EAFE consists of the country indices of 21 developed nations. 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 Center for Financial Planning, Inc. and not necessarily those of RJFS or Raymond James. Diversification does not assure a profit or protect against loss. Investments related to a specific sector, where companies engage in business related to a particular industry, are subject to fierce competition, the possibility of products and services being subject to rapid obsolescence, and limited diversification. Investing in emerging markets can be riskier than investing in well-established foreign markets. Investing involves risk and investors may incur a profit or a loss, including the loss of all principal.

U.S. Stocks - 1st Quarter 2012

Last year the S&P 500 – a bell-weather for American stocks – was statistically unchanged from a price perspective.  When you add in dividends, the index was up 2%.  You may be feeling a lot more bumps and bruises from the year in stocks than a flat 12-month return would indicate.  Markets had wild swings and Ron Griess of the Chart Store (Hat Tip ritholtz.com) reports that 2011 was the seventeenth most volatile year for the S&P 500 since 1928.  Perhaps not surprisingly, 2008 and 2009 were even more volatile.  All of this has presented a behavioral challenge for investors with the temptation to time the market or get off the bumpy ride.

As with anything, it is very difficult to predict volatility.  It’s best to plan, though, for more ups and downs.  Volatility seems to come in patches with 15 of the 17 most volatile years for the S&P coming between 1929 and 1939 or between 2000 and 2011.  Managing your investment behavior through allocation planning, regular rebalancing, or the advice of an investment professional is critical to help avoid paralysis or bad timing.

Returns of large US companies surged ahead of their smaller peers. While large company S&P returned 2%, the Russell 2000, a common index for small companies, was down 4%.  The Dow Jones Industrial Average, even bigger than the S&P as measured by market capitalization, returned 8%.  Still, smaller stocks have outpaced large stocks cumulatively since March 2009 (when using the same indexes).

Many have watched for large companies to outperform due to compelling valuations and diversified revenue sources.  This trend may continue with strong profit margins, cash on the books, and still interesting valuations relative to larger stocks.

Dividend-paying companies, especially those outside of the financial sector, rewarded their investors handsomely in 2011.   Dividends fulfilled their promise last year helping both the total return of companies as well as raising interest from investors for their companies themselves.

We still like dividends for reasons Angie Palacios, CFP® I explained in a recent blog post.  Dividend yields are attractive relative to interest that bonds pay across the world.  Furthermore, as more boomers retire and seek a more steady income stream (no small feat in a low-yield world), a strategy that includes dividends may remain attractive relative to their cash-hoarding peers. *Dividends are not guaranteed and must be authorized by a company’s board of directors.

International Markets - 1st Quarter 2012

International allocations are increasing portions of investment portfolios.  This isn’t a fluke.  International companies represent an increasing market cap of the world’s stock relative to the states.  Over the last 10 years, international investments almost doubled the returns of US investments (33.4% for the S&P 500 vs. 64.8% for the MSCI EAFE per JP Morgan Asset Management).  Blame for foreign investment woes were most strongly linked to a European debt debacle, Japan’s earthquake natural disaster, and concerns of slowing growth in China.

The world’s challenges are hard to ignore, especially in Europe.  Austerity is a big hurdle for economies to overcome.  Companies have been beat up along with their governments and we believe that longer term there may be compelling opportunities around the world.  The role of international investments in a diversified portfolio remains relevant today in our mind in spite of disappointing recent returns.

Please note that international investing involves special risks, including currency fluctuations, differing financial accounting standards, and possible political and economic volatility. Diversification does not assure a profit or protect against loss. Past performance does not guarantee future results. 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 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 art hos of Center for Financial Planning, Inc. 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.

Bonds - 1st Quarter 2012

Source: Morningstar, Inc.

It seems like bonds are defying gravity at this point.  Entering last year at near record lows for yields, fixed income, as measured by the widely recognized BarCap Aggregate Bond Index, returned 7.8% vs. virtually flat returns for large-cap stocks as measured by the S&P 500. As bond returns continued to levitate, yields deflated to new record levels.  US debt was downgraded mid-year, but markets asserted a strong vote of confidence with double-digit returns for long treasury bonds.

Where to next? Past returns are not a predictor of future performance – that’s what we’re told to say by our compliance officers and in my mind, this disclaimer could not be more apropos. With interest rates telegraphed to remain low, the Fed may delay dreaded rising rates, but the ability to replicate the returns of 2011 will be a major surprise. Diversification away from a traditional mix of government bonds may help, depending on your situation.

Diversification - 1st Quarter 2012

Our recent blog post titled “Death of Diversification?” noted that 2011 was an exceptionally poor year for diversified investment positions. You may ask what we meant by diversified. For our purposes, we were referring to asset classes that are not US stocks as measured by the S&P 500 and US bonds as measured by the BarCap Aggregate Bond indexes. 

A similar, although altogether more painful time period was 2008 where all but the most risk-averse assets were in free-fall. Past performance does not predict future returns, but history has a funny way of rhyming. In 2009, as markets determined the world was not ending, diversified portfolios were richly rewarded.

January’s returns offer a peek into the behavior of markets coming out of a period where diversification has not worked.

In the chart above we compare US Stocks & US Bonds to common diversifiers. This illustrates (on an admittedly smaller scale) another inflection point for diversification where additional asset classes contributed positively to returns similar to the time period starting in March 2009.

The jury is out as to whether this period favoring diversification will sustain itself through 2012. At some point the diversification ship will right itself and reward investors that hang on with variety’s smoothing effect.

* Large Cap Stocks – S&P 500, International Stocks – MSCI EAFE NR USD, Small Cap Stocks – Russell 2000, Commodities – Morgan Stanley Commodity-Related, US Bonds – BarCap US Aggregate, Global Bonds – BarCap Global Aggregate, High Yield Bonds – BarCap Corporate High Yield.

Benefits of Process - 1st Quarter 2012

Investors are prone to periods of underperformance regardless of strategy. The response to underperformance is an important consideration for the investor's future success. Nobel Prize winning behavioral psychologist points to process:

"Organizations are better than individuals when it comes to avoiding errors, because they naturally think more slowly and have the power to impose orderly procedures." ~ Thinking, Fast and Slow, Daniel Kahneman, 2011.

At Center for Financial Planning, we have an investment committee dedicated to upholding the very processes that hedge us as investors from common pitfalls while maintaining customized financial planning solutions for each client's unique situation. There are checks and balances so that changes for investments don't occur willy-nilly. Parameters anticipating discussion of process change are documented within our written procedure. Please click here to read the full post at Money Centered.

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 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 Center for Financial Planning, Inc., and not necessarily those of RJFS or Raymond James.