Wednesday, July 3, 2013

Taper Tantrum

From the Desk of Joe Rollins

I have some very good results to report as we move into the second half of 2013. That being said, the quarter was very volatile and we must analyze the negatives along with the positives in order to obtain a full understanding of everything that happened during the quarter. Nevertheless, the results were quite impressive.

While almost all of the financial markets posted negative results for the month of June, the second quarter results and the results for the first six months of 2013 were excellent. For the quarter ended June 30, 2013, the S&P Index of 500 Stocks had a return of 2.9%. For the year, that index recorded a return of 13.8%. The Dow Jones Industrial Average was up 3% for the quarter and 13.3% for the first six months of the year. The NASDAQ Composite was up 4.5% for the quarter – the best return of the indices – and its return for the first six months was 13.4%. The Russell 2000 small-cap index was up 3% for the quarter and its return for the first half of 2013 was 15.8%.

The first half of 2013 was the best first half of a year for the financial markets since 1999. As you may recall, the S&P 500 wound being up an amazing 21% for the 1999 year. We can only hope for a return of 21% for 2013, although that’s not likely to happen. Although none of us can forecast exactly what will happen for the rest of the year, we must concede that the first half was quite remarkable.

The real story during the first half of 2013 was the absolute turmoil in the bond market. For the second quarter of 2013, the Barclays Aggregate Bond Index was down 2.6%, and coincidentally, the Barclays was also down 2.6% for the first six months of 2013; for the last year, it’s lost 1.1%. It’s very unusual to see the bond market take such a big hit over such a short period of time.

Investors buy bonds expecting to not get much upward appreciation and instead look for stability and the small coupon that bonds pay. Rarely, however, do bonds take such a big hit when the other financial instruments are doing well. This supports our philosophy for diversification. No one can tell exactly what the future will bring, and I certainly wasn’t one who forecasted bonds taking such a big during this three-month period.

For the quarter ended June 30, 2013, the U.S. equity markets were the only safe haven. Almost all of the international funds traded on the downside except the Japanese-related funds, and the emerging markets were particularly hard-hit. Likewise, nearly all high quality bonds had a negative return for the 2nd quarter; even the low quality high yield bonds were negative in the 2nd quarter – although some etched out a small profit for the six-months ended. Most surprising to me was the municipal bond market, which took a tremendous hit this quarter; almost all municipal bonds traded negative for the six-months ended June 30, 2013. Undeniably, this has been a very unusual year so far.

As I have discussed before, the Fed has been purchasing $85 billion in bonds per month in an effort to keep interest rates low and encourage improvement in the housing market. In many respects, they have succeeded with the housing market rebounding in the United States with extraordinarily low interest rates. On June 19, 2013, Fed Chairman Bernanke indicated that if the economy continued to improve, the Fed would start “tapering” their purchases of these bonds later this fall.

Almost immediately, the equity and bond markets suffered an extraordinary loss: the DJIA lost over 700 points in less than a week’s trading time; the 10-year Treasury spiked from 2.2% to 2.6% almost overnight; and 30-year mortgages jumped from less than 4% to the mid-4% level almost overnight. Why did these significant moves occur over such a short period of time for what, in my opinion, wasn’t unexpected news from Bernanke?

You must ignore almost everything you know about investing to understand speculation. The hedge fund industry – a huge investor in the U.S. equity markets – must work on the margin to be successful. They have proven that they cannot invest money any better than a top quality mutual fund. Therefore, the only way they can succeed and bring value to their investors is to push the envelope. When the market is down, they can improve their returns by forcing it down even further. When it’s on the upside, they have to get an advantage either by borrowing money and investing it or finding some niche in the market they can exploit.

Since interest rates have been next to zero for several years, hedge funds have made a ton by borrowing money at a very low rate to buy high yield bonds and reporting the difference. This is fairly easy when you can borrow at one and invest at six, and earn a rate of return for the difference. However, that advantage also comes with immediate risk.

If interest rates were to suddenly increase, you would suffer losses on the debt and investment sides since you have leveraged the investment. This could be catastrophic for a highly leveraged hedge fund if interest rates were to move quickly. When Bernanke announced the Fed would likely begin tapering their purchases, the hedge funds had a “taper tantrum.” Anticipating that interest rates would invariably go up, the hedge funds suffered an immediate liquidation of close to $80 billion in high yield bonds almost overnight. This mass liquidation of bonds created havoc in the equity and bond markets over a relatively short period of time.

Fortunately, the Fed members announced the following week that tapering was not inevitable and would only occur if the economy continued to improve (which is exactly what Bernanke said in his conference on June 19th). After that explanation, the markets rallied some, although it still left virtually all equities and the bond market in losses for the month of June.

At Rollins Financial, we do not invest for the short-term, and we understand that market volatility is part of the game. While it’s interesting to understand why things happen, it’s more important to be able to rejoice in the results.

It would be crazy for me to report that the second half of 2013 will be as excellent as it was during the first half. While we’d all love for that to be the result, it would be foolish to forecast a return as good as we’ve enjoyed thus far in 2013. However, I also do not see a major downswing in the coming months.

The economy, undoubtedly, is somewhat better than it has been over the last few years. Even though the most recent quarter was reported at an anemic 1.8%, it continues to at least be positive. It appears to me that the 2nd quarter of 2013 will come in very near that 1.8% level, and therefore, it doesn’t appear that the economy is moving at an uncontrolled pace to the upside. Inflation continues to be mild at 1%, and corporate profits continue to be excellent. There is no question that corporate profits are decelerating, but they continue to be at all-time highs and are still growing, even if at a modest pace.

With the large hit that the bonds suffered in the second quarter, I believe that we’ve already seen the worst. I anticipate for bonds to continue improving as the year progresses because interest rates are still very low and the economy is not accelerating at a quick pace. As such, it’s too late to sell out of your bond funds and they are still required for diversification purposes in almost all portfolios.

The housing market has unquestionably vastly improved, and this positive news is evident in almost every segment of the market. As the housing market picks up, it will help improve the rest of the economy since so many segments of that market affect our economy on the whole.

What do I see happening over the rest of this year, and what should you to expect to earn in your portfolios? I must reemphasize that almost all interest-bearing certificates are earning next to nothing, a complaint that we hear from investors on almost a daily basis. Unfortunately, some investors continue to hold assets in cash earning zero, even when very conservative financial instruments can earn close to 4%. To a large degree, this period of low interest rates, in my opinion, will force the market higher.

With inflation under control, the economy not going gangbusters and real estate improving, I see corporate earnings continuing on a positive track. Even with the huge drain on the GDP from higher taxes in 2013, the economy continues to operate above break-even. Although Congress did everything they could to mess up the budget, sequestration has forced them to cut federal spending, and for the first time in over a decade, the federal deficit is actually falling. Hopefully sequestration will continue, and Congress – against its will – will be forced to continue to cut spending.

All of that said, I anticipate the markets to earn between 4% and 7% for the rest of 2013. The best markets in the world continue to be the U.S., and the correction in the bond market has already occurred. If you anticipate the markets continuing to earn at the aforementioned levels, why would you do anything other than invest for your future?

As always, the foregoing includes my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best regards,
Joe Rollins

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