While geopolitical risks continued to increase over the second quarter, the Federal Reserve continues to “taper” their quantitative easing program, and equity valuations remain a concern to many investors, U.S., International Developed, and Emerging markets were all positive for the quarter. Global Real Estate continued charging forward. The US and International bond markets were also positive. The only real negative about the markets today is the fact that so many individuals sat on the sideline in cash over the past few years while the markets have roared to life.
Market Summary – Second Quarter 2014 Index Returns
Image Credit: Dimensional Fund Advisors
The S&P 500 performance with selected headlines from Q2 2014:
Image Credit: Dimensional Fund Advisors
The above graph highlights some of the year’s prominent headlines in context of broad World Stock Market performance, as measured by the MSCI All Country World Index. These headlines are not offered to explain market returns. Instead, they serve as a reminder that investors should view daily events from a longer-term perspective and avoid making investment decisions based solely on the news.
World Asset Class Performance Summary
Equity markets posted positive performance for the quarter, led by emerging markets. This was the first quarterly period in which emerging markets had outperformed developed markets since the third quarter of 2012. REITs both in the US and in developed non-US markets outperformed equities. Large cap indices outperformed small cap indices in the developed and emerging markets, including the US. In general, value outperformed growth indices, though performance was mixed within size ranges and regions.
Image Credit: Dimensional Fund Advisors
Fixed Income – Q2 2014
Interest rates across all US fixed income markets declined during the second quarter. The 10-year Treasury note ended the quarter at 2.53%, a decline of 20 basis points over the period. The 30-year Treasury bond finished with a yield of 3.34%, a decline of 22 basis points. The decline in intermediate- and long-term rates, coupled with relatively unchanged short-term rates, led to a flattening of the US Treasury yield curve.
The 30-year Treasury bond returned 5.20% and continued to outpace all fixed income markets with a 13.80% return for the year. Long-term corporate bonds returned 4.40% for the quarter and 10.42% for the year, beating intermediate-term corporate bonds, which returned 1.77% and 3.49%, respectively.
Municipal revenue bonds slightly outpaced municipal GO bonds by 2.83% vs. 2.19% for the quarter. Long-term municipal bonds outperformed all other areas of the curve by returning 4.11% for the period and 10.05%
for the year.
Image Credit: J.P. Morgan Chase Asset Management
About the Yield Curve – (An Educational Time Out)
The slope of the yield curve is often used as a leading indicator of future economic growth, inflation, and recessions. One measure of the yield curve slope (i.e. the difference between 10-year Treasury bond rate and the 3-month Treasury bond rate) is included in the Financial Stress Index published by the St. Louis Fed. A different measure of the slope (i.e. the difference between 10-year Treasury bond rates and the federal funds rate) is incorporated into the Index of Leading Economic Indicators.
An inverted yield curve is often a leading indicator of economic recession. A positively sloped yield curve is often a leading indicator of inflationary growth. Work by Dr. Arturo Estrella & Dr. Tobias Adrian has established the predictive power of an inverted yield curve to signal a recession (note this does not mean it can be used to predict markets). Their models show that when the difference between short-term interest rates (he uses 3-month T-bills) and long-term interest rates (10-year Treasury bonds) at the end of a federal reserve tightening cycle is negative or less than 93 basis points positive that a rise in unemployment usually occurs. The New York Fed publishes a monthly recession probability prediction derived from the yield curve and based on Dr. Estrella's work.
All the recessions in the US since 1970 have been preceded by an inverted yield curve (10-year vs 3-month). Over the same time frame, every occurrence of an inverted yield curve has been followed by recession as declared by the NBER business cycle dating committee.
The Economy and the Market - Looking Forward
We maintain the view that markets risks have increased since the end of 2013, and that a slight increase in the risk premium is warranted for certain asset classes based on geopolitical events and on valuation relative to growth estimates. Lower global economic growth estimates may cause investors to view stock prices relative to expected earnings as too high in some asset classes. Although we agree that a few asset classes are a little too far over their skis from valuation perspective, we do not believe a full-scale “correction” will occur in the near term. Valuations in most asset classes have not moved far from their average, and equity dividend yields are still attractive relative to bonds. We also continue to be optimistic in the near to mid-term on the U.S. and global economy. Economic recovery has been very slow; but this is to be expected with such a deep recession and a financial crisis combined with a complete absence of fiscal policy out of Congress to help stimulate growth and shore up our aging infrastructure.
With all of that said, some asset classes still appear undervalued, and the economy continues to pick up momentum.
Image Credit: J.P. Morgan Chase Asset Management
Signs that the economic recovery is finally reaching lower tiers of the socio-economic scale of the American population are beginning to emerge. The energy boom also continues and will continue for the foreseeable future. Jobs are being created, providing consumers with the means to purchase goods. Inflation remains in check and is expected to remain that way for the foreseeable future, as evidenced by the slight flattening of the yield curve (which also is evidence of reduced expectations regarding global economic growth). The Federal Reserve is growing more confident in the recovery, evidenced by the Fed identifying an October target date to end QE3 (which was widely expected). The U.S. Economy is driven by the consumer, and the consumer appears to be gaining some footing. The following charts illustrate the recovering U.S. Consumer.
The U.S. Consumer is the primary driver of the economy.
Image Credit: J.P. Morgan Chase Asset Management
The U.S. Consumer has cleaned up their balance sheets and household net worth has reached record highs (although this phenomenon has mostly occurred at the top brackets of socio-economic status). Household debt payments relative to disposable personal income have declined greatly, meaning consumers have to use less of their income to pay debt and have more to spend (and save).
With the improvement in consumer financial circumstances comes a more optimistic consumer:
Image Credit: J.P. Morgan Chase Asset Management
There are reasons for consumers to feel optimistic.
Inflation remains in check:
Image Credit: J.P. Morgan Chase Asset Management
Job gains continue:
Image Credit: J.P. Morgan Chase Asset Management
Unemployment is coming down at all levels of education. However, as always, education matters (stay in school, kids):
Image Credit: J.P. Morgan Chase Asset Management
Corporate balance sheets have greatly improved as well. Unfortunately, we have not seen the Capital Expenditure outlays that many investors had hoped for at this stage in the recovery. Companies are still hoarding cash, but at some point return on investment will drive capital expenditures; and there is a lot of cash to put to work:
Image Credit: J.P. Morgan Chase Asset Management
What does all of this mean for your portfolio? No one, not even Nobel Prize winning economists, can tell with certainty where we are in the business cycle and what will happen tomorrow. It is unforseen events that drive market price movements; as what is known is already priced into the markets. It is critical that an investor tie their investment activity directly to probability of achieving their life goals through the financial planning process and maintain a diversified portfolio designed to achieve those goals. Too often individuals (and advisors) try to outsmart the market (i.e: all of the people who have sat in cash while the markets have roared over the past few years) and hurt themselves:
Image Credit: J.P. Morgan Chase Asset Management. Diversification does not guarantee investment returns and does not eliminate the risk of loss.
Notice in the pie chart above how adding a few asset classes to a portfolio can reduce the risk of a portfolio without significantly reducing return. This is a key element that many investors miss. Also illustrated above in a bar chart, you can see that the average investor barely beats inflation with their investing activities. This is due to a lack of diversification in their portfolio, lack of a rebalancing process, the lack of discipline, and/or the belief that they can “outsmart” and/or "time" the market. . Often these people get caught up in the news of the day and then, unfortunately, decide to reflect their beliefs about the stories in their portfolio.
Human beings love stories, but this innate tendency can lead us to imagine connections between events where none really exist. For financial journalists, this is a virtual job requirement. For investors, it can be a disaster.
“The Australian dollar rose today after Westpac Bank dropped its forecast of further central bank interest rate cuts this year,” read a recent lead story on Bloomberg.
Needing to create order from chaos, journalists often stick the word “after” between two events to imply causation. In this case, the implication is the currency rose because a bank had changed its forecast for official interest rates. Perhaps it did. Or perhaps the currency was boosted by a large order from an exporter converting US dollar receipts to Australia or by an adjustment from speculators covering short positions. Markets can move for many reasons.
For individual investors, financial news can be distracting. All this linking of news events to very short-term stock price movements can lead us to think that if we study the news closely enough we can work out which way the market will move. But the jamming of often-unconnected events into a story can lead us to mix up causes and effects and focus on all the wrong things. The writer and academic Nassim Taleb came up with a name for this story-telling imperative: the narrative fallacy.
The narrative fallacy, which is linked to another behavior called confirmation bias, refers to our tendency to seize on vaguely coherent explanations for complex events and then to interpret every development in that light. (As an aside, this does not just affect our investing behaviors but our political beliefs as well).
These self-deceptions can make us construct flimsy, if superficially logical, stories around what has happened in the markets and project it into the future.
The financial media does this because it has to; they are trying to attract readers and website “clicks”. Journalists are professionally inclined to extrapolate the incidental and specific to the systematic and general. They will often derive universal patterns from what are really just random events.
Building neat and tidy stories out of short-term price changes might be a good way to win ratings and readership, but it is not a good way to approach investing.
Of course, this is not to deny that markets can be noisy and imperfect. But trying to second-guess these changes by constructing stories around them is a haphazard affair and can incur significant cost. Essentially, you are counting on finding a mistake before anyone else. And in highly competitive and efficient markets with millions of participants, that’s a tall order.
There is a saner approach, one that doesn’t require you spending half your life watching CNBC and checking Bloomberg. This approach is methodical and research-based, a world away from the financial news circus.
The methodical and research-based approach, our approach, consists of looking at data over long time periods and across different countries and multiple markets. The aim is to find factors that explain differences in returns. These return “dimensions” must be persistent and pervasive.....persistent in all time periods and pervasive in all asset classes. Most of all, they must be cost-effective so that we may capture these dimensions in real-world portfolios.
Admittedly, this isn’t a story that’s going to grab headlines. "Nerds Use Academic Approach to Investing" is not going to attract a lot of attention. However, using the research-based method and imposing a very high burden of proof, this approach resists generalization, simplification, and using one-off events to jump to conclusions.
It may not be the exciting story; but for most investors, it’s the right story.
1. 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 creditworthiness 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 Nevada, New York, North Carolina, South Carolina, and Texas.