“Individuals who cannot master their emotions are ill-suited to profit from the investment process” Ben Graham, economist, investor, and mentor to Warren Buffett.
A World of Trouble June 19, 2012
With 2012 nearly half over, markets around the world are still debating whether to anticipate recovery or disaster. The US stock market’s overly optimistic 12% rally in the first quarter was fully relinquished in April and May. Since then stocks have erratically but impressively scaled a “wall of worry” to regain a 6% appreciation.
Sunday’s narrow victory of Greece’s pro-Euro, conservative New Democracy party was viewed as a positive. But it does not clarify which coalition will govern, nor does it quell investor fears regarding greater Europe. With limited visibility, trading volumes have dropped to nothing and volatility has been exacerbated. Greece is but a minor problem in comparison to Spain and Italy, and the schedule of June meetings and events in Europe should keep the pundits working overtime.
Europe remains a common currency region, with disparate country economic issues, and lacks the common Treasury willing and able to support to the Euro. Europe has been “kicking this can down the road” for a long time. Are they finally running out of road?
Our domestic economic news has remained sluggish, though not disastrous. As the Federal Open Markets Committee (FOMC) meets, certainly Europe and its impact on the US will be discussed. Some foresee another stimulus (QE3), though a continued commitment to low interest rates and continued (or expanded) operation twist is more likely. We must remember that future QE stimulus suffers from the law of diminishing returns. While stimulus improves liquidity, it does nothing to address the issue of solvency. The US and Europe both carry too much debt, which must eventually be paid or written off. Solvency is the more difficult issue to address.
The Fiscal Cliff
A new phrase has entered the national lexicon: “Fiscal Cliff.” This refers to the concerns regarding an abrupt economic slowdown in 2013 if taxes rise and government spending falls. This includes the expiration of Bush tax cuts and the payroll tax cut, federal spending cuts, and new taxes to pay for health care legislation. Unfortunately, in the current tumultuous campaign environment, it is doubtful that Congress will pass a significant legislation prior to Election Day. Some economists estimate that the full brunt of the fiscal cliff could cut 3.50% to 4.00% from US GDP. As the economy is currently growing at less than that rate, this would push the US into recession in 2013.
Blowing Bubbles
I'm forever blowing bubbles, pretty bubbles in the air,
They fly so high, nearly reach the sky,
Then like my dreams, they fade and die.
Fortune's always hiding, I've searched everywhere,
I'm forever blowing bubbles, pretty bubbles in the air. (Tin Pan Alley tune, 1919)
After 30 years of declining interest rates, there is a bubble in the bond market, though I do not see it ending until an economic recovery truly takes hold. In 2007, 10-year Treasury bonds yielded around 5%. Last week that rate dipped below 1.60%. Not only does the Fed’s policy of low rates penalize savers, investors, and retirees, but it fuels a bubble. While he Tech Bubble for the late 90’s was fueled by investor greed, the current Bond Bubble is fueled by investor fear. We fear that both will end similarly.
Risk-Off may be a risk assumed
A quick glance at Q2 ETF performance provides a telling insight to the market. Twenty year plus Treasuries (TLT) is up over 13%, Utilities (XLU) is up over 6%, where large cap and small cap domestic stocks (SPY & IWM) are down over 4% and 6% respectively. The market is scared and trading defensively.
According to Research Affiliates, at the end of 2011 the 10-year expected return for equities is 6%, the 10 year bond yield is 2%, and the expected 10 year return of a 60% equity / 40% bond portfolio is only 4.40%. Will this be sufficient to support baby boomers’ retirement expectations?
Following two 50% market declines in a decade, and more scandals and scares than we care to recount, it’s no wonder that Main Street prefers bonds. Most recently, I cannot think that the over-promoted Facebook IPO debacle has helped foster faith either. It’s quite possible, according to Strategas, that these “safe” bond investments will need to produce losses before the public reconsiders their equity phobia.
There is some constructive optimism out there. Commentary from both Fidelity and Leuthold Group draws a comparison of the current markets to those of the 40’s and 70’s. Those were tough periods for stock investors that resulted in similar lack of market faith and public support of equities. But note that the 50’s and ’74-’80 markets produced attractive equity returns.
Hedging your longevity risk
One of the largest variables in making projections for those approaching retirement age is how long we estimate their life span will be. One interesting option is longevity insurance – a deferred annuity that provides income for life beginning after age 80 or 85. When incorporated properly, this option may remove concerns about longevity, and may allow investors to more comfortably plan and invest.
In Closing
Without a doubt it’s been a tough investing environment year-to-date, and unfortunately we don’t see this changing quickly. Will 2012 repeat 2011, where we started strong, retrenched, and rode a roller coaster of volatility throughout the year? Given the multitude of economic problems worldwide, and the uncertainty regarding the election and the fiscal cliff, we expect that the markets remain volatile for the balance of the year.
While these are challenging markets, we continue to evaluate new opportunities, and will continue our efforts to allocate assets to produce reasonable returns with overall lower volatility.
Best wishes,
Dickson
