Tuesday, September 9, 2014

Time Passes By

From the Desk of Joe Rollins

I recently just passed my 65th birthday and I am starting to realize as I get older how quickly time passes. It is actually hard to believe that the firm started in my living room in 1980 has just past its 34th birthday. I never had any intentions of being an employer, I just wanted to prepare tax returns correctly and that was the reason for establishing the firm. I saw so much that I disliked in large accounting practices, but mainly I disliked seeing my clients mistreated. Therefore, the origin of the practice began in a small bedroom in Fairburn, Georgia, and now 34 years have passed so quickly.

Below are two pictures from Ava’s first day of school at age two and age three. Not that it has anything to do with what I am writing, but if I do not put a picture of Ava in the blog, I am heavily criticized. It seems like only yesterday she was born, and now three and a half years old, she is probably at the peak of her intellectual ability.

The main reason why I wanted to make this point is because over the last year we have enjoyed extraordinary success by investing. For the one year period ended August 31, 2014, the Standard & Poor’s index of 500 stocks is up a sterling 25.3%. The NASDAQ Composite is even better at 29.1% and the Dow Jones Industrial is up 18%. Given that the rate of inflation is currently around 2%, there are very few times that you can enjoy a rate of return 10 to 12 times the rate of inflation. It is been an extraordinary year by virtually anybody’s standards.

I am asked almost every day, “When should I expect the large market crash?” During the month of July, when the market was volatile and traded to the downside, there could not have been more market forecasters predicting the ultimate demise of the financial markets. Do not get me wrong, there are plenty of reasons in the geopolitical arena that would lead to this conclusion. It is almost a war everyday throughout the rest of the world, and frankly things do not appear to be getting any better in the Middle East. Yes, a major war with Russia would have a terrible effect in Europe; however, I question whether it would have much effect on the United States.

As I wrote in the July blog, I did not think that the market volatility was much to be concerned about, especially since the fundamentals were still exceedingly strong. Also, I argued that earnings were great, interest rates were low, and the economy appeared to be on the upswing, and therefore, I did not anticipate a major move to the downside in the financial markets in July. I guess I was right!

The month of August was quite an excellent month for investing. The S&P 500 was up 4% in August, and is up 9.9% for the year 2014. The NASDAQ Composite was up 4.9% in August and up 10.5% in 2014. The Dow Jones Industrial Average was up 3.5% in August, and remains up at an excellent 4.7% in 2014. As comparison, the Barclays Aggregate Bond Index was up 1.1% in August, but still up an impressive 4.7% in 2014 for bonds.

Many times a week, I meet with you (clients) and I am always blown away by how impersonal and uninformed the financial advice is that others receive elsewhere. I guess there must be a chart out there somewhere that says if a person is of a certain age, they require a “set” combination of stocks and bonds, notwithstanding any other information. It is amazing to me that someone who has never met a client and knows nothing about their financial life, needs, or what their time horizon is, can recommend any type of investment protocol.

As a matter of fact, we have some clients come in and they have never actually spoken with their financial adviser. They deal with a salesman who sends some money off to some unknown location for investing. I often ask them if they had ever talked to the person who invests their money. Often times, the answer is no – they do not even know who that person would be. The big difference between the way we do things and the way other people invest money is that we attempt to fully understand the client’s needs and invest with knowledge, not off an investors’ chart that probably has not been updated in decades.

A thought popped in my mind the other day, my first recognition (of any type) of interest in the financial markets began in 1980. At that time, we were enjoying a new administration with Ronald Reagan during a time when America felt good about itself. We had gone through serious inflation during the 70’s and interest rates were totally out of control. I vividly remember when the 10-year Treasury rate nudged up against 16% in 1981. It is important that you understand how much interest rates affect financial markets. I am enclosing a chart below that illustrates the 10-year Treasury beginning in 1980 up to today.

In reviewing the report, you will note that interest rates topped out around 16%, and are now currently down approximately to 2.4%. However, if you draw a straight line, you will note that for the last 34 years, the trend in interest rates has always been lower. Therefore, unless you have a financial adviser that is as old as I am, they have never witnessed a negative bond market in their LIFETIME!

Even though interest rates in 2014 have been stubbornly low, this has been good for the financial markets, however bad for savers. Interest rates paid at banks are virtually zero, and if anything will continue to go lower – not higher. However, we know that the party is beginning to end. We know that interest rates will go up in 2015, we just do not know when. When interest rates start to move higher, there will be a large number of investors who are currently invested in bond funds, that will see a negative rate of return on an investment they were told was solid.

Maybe for the first time, a lot of financial advisers will see a negative bond market and really not know how to advise their clients. As we have for the last several years, we have avoided bonds since we anticipate the trend in bonds to be negative; no one knows the exact date or time, we think it is coming. In the meantime, since equities have been performing beautifully, there is no reason to take the risk that I believe bonds are today. This also goes for bond-like investments, such as real estate and some forms of utility stocks. Many of these financial instruments trade much like bonds, and will be adversely affected, as will bonds, when interest rates go up. Therefore, we have been trimming back our exposure in bonds and focusing more on investments in equities.

There is no question that the government’s manipulation of interest rates is helping the financial markets. Even through the U.S. Treasury at 2.4% is extraordinarily low, it is not as low as the 10-year German equivalent treasury. That current rate is 1%. Likewise, how could a country as economically unstable as Spain issue bonds with lower interest rates than the United States if it were not for government market manipulation? All of this is to say that governments can hold down interest rates for a while, but at some point market pressure will require higher rates. When those higher rates come, the principal of bonds will be endangered. Beware… you have been warned!

I saw an interesting article in Barron’s this weekend where they were analyzing market tops. The one that caught my interest was the market top of 2000, as compared to today in 2014. The most interesting aspect of this chart where, for the most part some are provisioned similar ratios existed, the huge differential was in the amount of the 10-Year Treasury. In 2000, the 10-Year Treasury was 6.2%; 4.7% in 2007; and 2.4% in 2014. Arguably, when interest rates are as high as they were in the prior years, an investor would have an incentive to move from equities into interest rate instruments. Today, moving from equities to the 10-Year Treasury would not be beneficial, since the 10-Year Treasury barely exceeds the rate of inflation today; much less over a ten year period.

Therefore, even though the markets rallied significantly during the month of August, I maintain my position that stocks will continue to trend higher as the year progresses. While it certainly may not be as dynamic as August, I do anticipate them to increase. It certainly would not surprise me to see a 3-4% additional gain between now and the end of 2014. Yes, there will be scary days and geopolitical events will shake our confidence, but do not read the front page of the New York Times to get your financial news. If you analyze interest rates, earnings, and the economy, you will know a lot more about the financial news than most people giving advice on TV.

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

Best regards,
Joe Rollins