Geopolitical risks have begun to look less like a hot war and more like an economic cold war as Russian troops pull back from Ukraine while, behind the scenes, trade and currency deals are being made. U.S. economic growth remains modest, with Canada and Britain as the other bright spots in a relatively dull economic world. Governments around the world have continued to be a fiscal drag on economic growth, including our own. The Federal Reserve continues to “taper” their quantitative easing program. Unemployment in the United States has fallen below 6% for the first time in years. Corporate profit margins continue to reach record heights. Inflation in the U.S. finally nipped at 2% year-over-year, and should accelerate slightly next year as the labor market continues to heal. However, global deflationary pressures are still persistent and could worsen as China slows down and the Eurozone faces the potential for a "triple-dip" recession due to continued austerity measures and tensions with Russia. The European Central Bank has hinted at the potential for a large scale quantitative easing program, much to the chagrin of German Chancellor Angela Merkel and her party; and Germany will likely attempt to block any move by the ECB to engage in any large scale bond purchasing program. Concerns about the spread of dangerous pathogens have taken center stage (although books were written about the potential for such a pandemic of hemorrhaghic viruses all the way back in 1992). Faced with increased uncertainty about the future, the risk premium expanded in global equity markets, with International Developed Stocks declining the most. The U.S. Stock market was largely flat for the quarter, with the best performance coming from the Bond markets.
Market Summary – Third Quarter 2014 Index Returns
Image Credit: Dimensional Fund Advisors
The S&P 500 performance with selected headlines from Q3 2014:
Image Credit: Dimensional Fund Advisors
World Asset Class Performance Summary
The broad U.S. equity market had flat-to-slightly-positive returns for the quarter. Small cap stocks in the US underperformed large cap stocks, with US small cap indices posting negative returns. Most equity markets outside the US had negative performance in US dollar terms. Currency movements played a role; the dollar appreciated against most currencies. In developed markets outside the US, large cap indices outperformed
small cap indices. In the emerging markets, however, small cap indices outperformed large cap indices. Value underperformed growth indices in developed markets across size ranges, but in emerging markets value outperformed growth in large caps but underperformed in small caps. REITs recorded negative returns in the US and in developed non-US markets.
Image Credit: Dimensional Fund Advisors
Fixed Income – Q3 2014
Interest rates across all US fixed income markets were mixed during the third quarter. The 10-year Treasury note ended the period at 2.49%, generally unchanged from the previous quarter. The 30-year Treasury bond finished with a yield of 3.21%, registering a decline of 13 basis points. While intermediate- and long-term rates declined, short-term rates increased. The 5-year Treasury note ended the period at 1.78%, up 16 basis points, while the 2-year Treasury note was up 13 basis points, finishing at 0.59%.
Long-term corporate bonds returned just 7 basis points in the quarter but are ahead 11.30% for the year. Intermediate-term corporate bonds lost 14 basis points in the quarter but are still ahead 3.47% for the year.
Municipal revenue bonds slightly outpaced municipal general obligation bonds by 1.97% vs. 1.48% for the quarter. Long-term municipal bonds continue to outperform all other areas of the curve, returning 2.69% for the period and 13.01% for the year.
Image Credit: Dimensional Fund Advisors
About the Yield Curve – (An Educational Time Out)
As we discussed last quarter, 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 necessarily 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. Here is a look at the yield curve prior to the dot-com burst at the beginning of the century:
The yield curve is depicted on the right and the S&P 500 growth is the blue line on the right. The red line going straight up and down in the S&P 500 chart shows where in the timeline the yield curve on the right is derived from, in this case it was August 16, 2000. Once can see what happened to the stock market after this time.
Here is a look at the yield curve prior to the Great Recession (June 28, 2007), which officially began in December of 2007:
Here is a look at today's yield curve:
Unfortunately the yield curve in Europe is looking increasingly flat; and action from the European Central Bank will likely be a necessity soon.
The Economy and the Market - Looking Forward
Last quarter we mentioned that we felt that stock price decrease (an increase in the risk premium) was warranted based on geopolitical events and on valuation relative to growth estimates. As we pointed out, the potential for lower global economic growth estimates may cause investors to view stock prices relative to expected earnings as too high in some asset classes; and this seemed to play out in the equity markets. We did not believe a full-scale "correction" would occur in equities during the quarter, although we certainly did get close to a full correction in some sub-asset classes. Valuations in most equity asset classes have now improved, and equity dividend yields are now again very attractive relative to bond yields. The dividend yield at the time of this writing of the iShares MSCI EAFE index fund is 3.74% (with equity upside) versus a German 10-year Bund yield of 0.75%; and stock valuations are not at excess. We do believe that the European Central Bank will be forced to take monetary policy action (either a rate cut or bond purchasing program) as an indirect remedy for European economic malaise; as the best option, fiscal stimulus from governments, is not likely to be a political reality, especially in Germany. With that said, as the Euro declines in value relative to the Dollar, European goods and services become cheaper for U.S. consumers and businesses; who happen to be in the best economic shape in years and whose demand could help ease some of the Eurozone's economic headwinds. We continue to be optimistic in the near to mid-term on the U.S. economy. However, it is clear that government action (such as a trade war with Russia) and inaction (lack of fiscal stimulus to help weakened economies with high unemployment) have dramatically muted economic expansion. Continued weakness in the Eurozone and Asia would serve as an economic drag on the United States as well. As has been the story since the Great Recession, investor eyes will be on the Central Banks.
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.
Image Credit: J.P. Morgan Chase
Maintaining a diversified portfolio helps "smooth" returns over the long run, but we need to psychologically prepare ourselves that in any given year losses will happen in portfolios. Stock markets rise and fall, as do commodities, real estate, and bonds. The key to success is knowing what to do when those events occur; and ensuring those actions are backed by empirical evidence, not simply emotion. When markets move dramatically our rebalancing process kicks in; harnessing the power of capital markets as opposed to fighting them. We also have a cash management program in place for those who are taking distributions from their accounts that takes into consideration and plans for periods of market tumult.
If during the course of the next few months the market volatility becomes a concern for you, please contact your LTWM financial advisor, or feel free to contact me (Richard Dee) directly so we can use your query as an opportunity to help foster a better understanding of the capital markets and how we use them in order to achieve our life goals.
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.