The U.S. stock market, global real estate, and bonds all performed well in the 2nd quarter. International developed stocks underperformed due to the unexpected success of the Brexit vote; however, as we foresaw in our blog on the subject, have already recovered: http://www.laketahoewealthmanagement.com/blog/dont-serve-detention-brexit-club-weekend. The U.S. stock market dropped 5.5% in two days right after the U.K. voted to leave the EU on June 23rd and then recovered over the last week of June. The VIX volatility index spiked to 26 and then dropped down to 14.7 for the largest decline on record (down 42% in one week). Once again, it would have been a poor decision for a long term investor to sell out of stocks due to the extreme negative volatility that lasted two days. We are pleased to report that not one client served detention with the “Brexit Club”.
A larger sample of asset class returns shows the strength of real estate and value stocks in the U.S, both in small cap (Russell 2000) and large cap stocks (Russell 1000), while international value stocks lagged due to the difficult “negative interest rate” environment in Europe, which make it a challenge for banks to make money with their lending operations.
Emerging Markets continued to rebound over the past two quarters from a challenging 2015 as commodity prices have recovered slowly but surely. Both WTI and Brent Crude Oil have traded around $50 for weeks, which helps reduce bankruptcy risk in the energy sector. Real Estate was the best performing asset class during the first quarter and the trend continued during the second quarter. Real Estate Investment Trusts (REITs) perform well in a declining interest rate environment since much of their interest expense is variable and will go down along with interest rates.
Bond markets around the world were positive due to a sizeable parallel shift down in the yield curve and the 10-year Treasury Bond hit at an all-time low yield of 1.35% on Tuesday, July 6th. (all maturities except the one-month Treasury Bill saw interest rates decline, see chart below).
When the yield curve shifts down across all time periods, the longer duration bonds are going to perform better and that is exactly what is happening year to date. The leading bond sector is long term government bonds.
One cannot time markets and typically the short term is just noise. Here is a sample of how the world stock market responded to headline news during the last quarter and the last year (notice the insert of the second graph that compares the last 12 months to the long term):
A DEEPER LOOK
The second quarter bond rally was fueled by a lack of inflation, slow global growth, the Federal Reserve backing away from their planned summer rate hike and, finally, the volatility immediately after the Brexit vote. One reason interest rates in the U.S. are hitting new record lows is because U.S Treasury Yields are higher than the vast majority of government bonds around the globe, stoking demand for U.S. Treasuries. The 30-year U.S. Treasury had a yield of 2.13% as of July 7th, which is considerably higher than government bond yields in Europe and Japan. Amazingly, the entire Swiss Yield Curve recently went negative, which means an investor has to accept a negative return for any government bond of any maturity (including the 30 year). The Swiss Yield Curve can be viewed here:
https://www.six-swiss-exchange.com/services/yield_curves_en.html
The German Yield Curve is negative out to 15 years and France’s is negative out to 8 years. Many of the other developed market government bonds around the world are below 1% for maturities out to 30 years so global bond investors are looking to the U.S. Treasury bond market for attractive yields (as small as they are), pushing interest rates down. Usually such low bond yields are due to a flight to safety, which means stocks may be at risk in the future. Another explanation is the strong force of deflation, due to the very high levels of debt around the world, the aging work force in the major economies of the U.S. (our labor force participation rate is declining with no sign of reversing), Japan and Europe; and the lack of major global fixed investment spending. The U.S and Europe bond yields continue to follow the “Japan Deflationary Experience” of the nineties. We continue to monitor the discussion of potential bank bailouts in China and Europe over large holdings of non-performing loans (NPLs). One reason why deflation was so bad for so long in Japan was the high level of NPLs. At the very least, we expect to experience lower interest rates; and for longer than expected just one quarter ago. It is our hope that this environment will spur world governments to engage in fiscal economic stimulus measures; but given the global political backdrop, it is not possible to forecast whether that dream will become a reality.
Low interest rates support higher stock valuations since the cost of corporate debt is so much lower, and dividend-paying stocks become more attractive. Price to Earnings (P/E) ratios could expand and stocks could appreciate further as long as the economy remains in an expansionary phase. Lower interest rates also support the housing market and boosts refinancing activity. It is easy to find a 15-year fixed mortgage rate close to 2.8% and 30-year mortgage rates below 3.5%. Consumer spending continues to show surprising strength in the U.S. Employment is strong and the 4 week moving average for claims of employment insurance is at new lows. However, relative and intrinsic valuations are stretched and the multiple least manipulated by accounting, the Price to Sales ratio, for the S&P 500 hit a new record high of 1.84 at the end of June. Large companies can improve their per share earnings by lowering expenses and buying back their own stock, so P/E ratios have to be viewed with caution. Revenue growth for the S&P 500 is closely tied with GDP growth, which is currently challenged with the declining growth of workers and the real output per worker (declining productivity) from previous time periods. As Janet Yellen discussed in her latest testimony, the U.S. economy is facing headwinds that may not be temporary. We do not know the direction of the stock or bond markets in the short term over the next quarter or two. We do see a meaningful probability of recession in the U.S. in the near future, given the long business cycle expansion since the great recession of 2009; but the future is uncertain and forecasts are more often wrong than right.
CONCLUSION
Valuations are elevated, global growth is very low, and global debt levels are very high. It is folly to invest according to market forecasts by rotating sectors and asset classes; and potentially very damaging to your investment return to completely remove stock exposure during periods of negative volatility. It is most important to position your portfolio for the long term, tied directly to “what the money is there for”. We discussed this in the conclusion of our previous blog from last quarter.
So as our friends across the pond have famously quoted: Keep Calm and Carry On.
Standardized Performance Data and Disclosures
Russell data © Russell Investment Group 1995-2014, all rights reserved. Dow Jones data provided by Dow Jones Indexes. MSCI data copyright MSCI 2014, all rights reserved. S&P data provided by Standard & Poor’s Index Services Group. The BofA Merrill Lynch Indices are used with permission; © 2013 Merrill Lynch, Pierce, Fenner & Smith Inc.; all rights reserved. Citigroup bond indices copyright 2014 by Citigroup. Barclays data provided by Barclays Bank PLC. Indices are not available for direct investment; their performance does not reflect the expenses associated with the management of an actual portfolio.
Past performance is no guarantee of future results. This information is provided for educational purposes only and should not be considered investment advice or a solicitation to buy or sell securities. Diversification does not guarantee investment returns and does not eliminate the risk of loss.
Investing risks include loss of principal and fluctuating value. Small cap securities are subject to greater volatility than those in other asset categories. International investing involves special risks such as currency fluctuation and political instability. Investing in emerging markets may accentuate these risks. Sector-specific investments can also increase these risks.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, liquidity, prepayments, and other factors. REIT risks include changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and credit worthiness of the issuer.
Lake Tahoe Wealth Management, LLC is an investment advisor registered in the States of Nevada, New York, North Carolina, South Carolina, and Texas.
Principal Risks:
The principal risks of investing may include one or more of the following: market risk, small companies risk, risk of concentrating in the real estate industry, foreign securities risk and currencies risk, emerging markets risk, banking concentration risk, foreign government debt risk, interest rate risk, risk of investing for inflation protection, credit risk, risk of municipal securities, derivatives risk, securities lending risk, call risk, liquidity risk, income risk. Value investment risk. Investing strategy risk. To more fully understand the risks related to investment in the funds, investors should read each fund’s prospectus.
Investments in foreign issuers are subject to certain considerations that are not associated with investment in US public companies. Investment in the International Equity, Emerging Markets Equity and the Global Fixed Income Portfolios and Indices will be denominated in foreign currencies. Changes in the relative value of these foreign currencies and the US dollar, therefore, will affect the value of investments in the Portfolios. However, the Global Fixed Income Portfolios and Indices may utilize forward currency contracts to attempt to protect against uncertainty in the level of future currency rates (if applicable), to hedge against fluctuations in currency exchange rates or to transfer balances from one currency to another. Foreign Securities prices may decline or fluctuate because of (a) economic or political actions of foreign governments, and/or (b) less regulated or liquid securities markets.
The Real Estate Indices are each concentrated in the real estate industry. The exclusive focus by Real Estate Securities Portfolios on the real estate industry will cause the Real Estate Securities Portfolios to be exposed to the general risks of direct real estate ownership. The value of securities in the real estate industry can be affected by changes in real estate values and rental income, property taxes, and tax and regulatory requirements. Also, the value of securities in the real estate industry may decline with changes in interest rate. Investing in REITS and REIT-like entities involves certain unique risks in addition to those risks associated with investing in the real estate industry in general. REITS and REIT-like entities are dependent upon management skill, may not be diversified, and are subject to heavy cash flow dependency and self-liquidations. REITS and REIT-like entities also are subject to the possibility of failing to qualify for tax free pass through of income. Also, many foreign REIT-like entities are deemed for tax purposes as passive foreign investment companies (PFICs), which could result in the receipt of taxable dividends to shareholders at an unfavorable tax rate. Also, because REITS and REIT-like entities typically are invested in a limited number of projects or in a particular market segment, these entities are more susceptible to adverse developments affecting a single project or market segment than more broadly diversified investments. The performance of Real Estate Securities Portfolios may be materially different from the broad equity market.
Fixed Income Portfolios:
The net asset value of a fund that invests in fixed income securities will fluctuate when interest rates rise. An investor can lose principal value investing in a fixed income fund during a rising interest rate environment. The Portfolio may also be affected by: call risk, which is the risk that during periods of falling interest rates, a bond issuer will call or repay a higher-yielding bond before its maturity date; credit risk, which is the risk that a bond issuer will fail to pay interest and principal in a timely manner.
Risk of Banking Concentration:
Focus on the banking industry would link the performance of the short term fixed income indices to changes in performance of the banking industry generally. For example, a change in the market’s perception of the riskiness of banks compared to non-banks would cause the Portfolio’s values to fluctuate.
The material is solely for informational purposes and shall not constitute an offer to sell or the solicitation to buy securities. The opinions expressed herein represent the current, good faith views of Lake Tahoe Wealth Management, LLC (LTWM) as of the date indicated and are provided for limited purposes, are not definitive investment advice, and should not be relied on as such. The information presented in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, LTWM does not guarantee the accuracy, adequacy or completeness of such information.
Predictions, opinions, and other information contained in this presentation are subject to change continually and without notice of any kind and may no longer be true after the date indicated. Any forward-looking statements speak only as of the date they are made, and LTWM assumes no duty to and does not undertake to update forward-looking statements. Forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time. Actual results could differ materially from those anticipated in forward looking statements. No investment strategy can guarantee performance results. All investments are subject to investment risk, including loss of principal invested.
Lake Tahoe Wealth Management, LLC is an investment advisor registered in the States of California, Nevada, New York, North Carolina, South Carolina, and Texas.
