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Are the Bond Markets Headed for a Fall?

Written by Gerald Gasber, CFP®, CIMA®.

Since the onset of the Great Recession, the Fed has driven interest rates to near zero, facilitating one of the biggest bond bull markets in history. Now, many investors believe that a rate increase is just around the corner. After all, despite media quips about “QE Infinity” it is simply not feasible for the Fed to continue buying its own intermediate-and-long-term bonds forever.

At a recent conference, Atlanta Fed President Dennis Lockhart said that he expects the U.S. central bank to begin raising rates in mid-2015 while an October 2013 survey of 50 top economists by the Wall Street Journal forecast a near one percent rise in rates by the end of 2014. Of course it’s important to remember that an early 2010 Wall Street Journal survey of economists predicted a 4.24% 10-year Treasury yield by year end. Ultimately rates actually declined, finishing the year at 3.30%. It should therefore come as no surprise that a 2005 study by professors at the University of North Carolina finds economists’ predictions of interest rates to be less accurate than a coin flip.

A Stopped Clock is Right Twice Every 24 Hours

But what if economists are finally right and the Fed does allow interest rates to rise? What in particular does this mean for bond investors? Bonds are unique compared with other investments in that a given return stream is well defined due to a highly certain income stream. As a result, bonds are uniquely affected by movements in interest rates. Rising rates lead to higher yields and lower prices (i.e., capital losses) and vice versa.

The sensitivity of a bond’s price to changes in interest rates is measured by duration. Duration is a common metric for evaluating interest rate risk in bond investments and the rule of thumb is that if interest rates increase 1 percentage point, a bond’s value will drop by approximately the bond’s duration. Of course there are other factors that will impact a bond’s price but for the sake of this discussion we will use duration as the primary factor.

Impact of Rising Rates on Bonds

At the time of this article, the yield on the Barclay’s Capital U.S. Aggregate Bond Index stood at 2.3% with duration of 5.7 years. In the most simplistic of examples, a 1 percentage point rise in yield during a 12-month period would lead to a new yield of 3.3% and a capital loss of -5.7%. The expected total return during that period would be the average of the starting and ending yields, 2.8% plus the capital loss associated with the rising yields, -5.7 or -2.9%. The good news is that following the 1 percentage point rise in rates, the initial expected return for year 2 is 3.3%, instead of 2.3%.

But what happens if interest rates unexpectedly rise by a significant amount, say 4 percentage points? Such a move has happened only twice in the United States, once in 1980 and again in 1981, as the Federal Reserve drove interest rates higher in an effort to combat high inflation. But in relative terms, a rate jump from 2.3% to 6.3% would constitute a 170% change in rates – a change that has never occurred in the United States. At -22.8% (4 x 5.7), the price decline in year 1 would represent the worst year ever for U.S. bond investors (the actual worst 12-month return for the Barclay’s Capital U.S. Aggregate Bond Index was -9.2% during the 12 months ended March 31, 1980). However, the new yield starting in year 2 is of greater importance as our diversified investor would now expect a 6.3% return going forward. Three years following the hypothetically worst bond market ever, the diversified bond investor would be back in the black simply by reinvesting interest distributions.

Putting a Bond Bear Market in Context

When evaluating the potential risks in the bond market, it is critical to remember why bonds are part of a well-thought-out asset allocation plan – to diversify the risk inherent in the stock market. Simply put, a potential bear market in bonds is dramatically different from a bear market in stocks. While the common definition of a bear market in stocks is a 20% decline in prices, the broad U.S. bond market has never experienced a -20% return. In addition, it is important to bear in mind that while rising interest rates may mean a modest decline in bond prices, they also mean higher nominal returns over the long run.

Future Testing

Written by Jim Parker.

Much financial news purports to be about the future but is really just an account of the past. As a result, many investors project what has already happened onto an imagined future. There’s another way of framing this problem.

It’s understandable that investors, with the help of a necessarily short-term-focused media, will tend to focus most of their attention on what has happened in financial markets in the past month, week, day, or even hour.

When stocks have fallen heavily in price, for instance, this is routinely reported as, “More bad news for investors today...” In fact, unless you plan to liquidate your portfolio that particular day, it is unlikely to be bad news at all.

The media could just as easily say, “Stocks went on sale today, as falling prices offered investors higher expected returns...” If you are a long-term investor, the key issue is how your portfolio performs from now on, not what happened yesterday.

In this way, investment is about the future, not the past. And because the future is unknown, we should strive to manage the uncertainty by diversifying across stocks, sectors, asset classes, and countries. While diversification does not eliminate the risk of market loss, to do otherwise is to take unnecessary risk.

The second assumption the financial media makes is that the future is the same for everyone. In reality, of course, our futures diverge depending on our age, family circumstances, jobs, incomes, and other factors.

One person may be focused on paying for a college education for their children or caring for aging parents. Another may be looking toward buying a home, saving for a vacation, investing an inheritance, or changing careers.

Everyone’s future is different, which means the investment strategy each of us adopts will vary. Some will want a strategy that delivers regular income; others will be more focused on capital growth. Some will be risk takers, others risk-averse.

From this, it should be evident that if the future looms differently for each of us, risk is not just one thing. It is not just the volatility of the market day to day or a simple statistical metric that can be measured. Risk can be felt differently depending on your age, your dependents, the industry you work in, the country you live in, the currency you consume in, and your accumulated assets and liabilities.

This is why an assessment of the future and the uncertainty surrounding it should not just be approached from the level of the overall market but from the needs of each individual. That is the role of a qualified financial advisor: to help connect each individual’s circumstances and needs to their goals.

None of us can control the future. Risk can be quantified up to a point, but risks can vary greatly depending on the individual. In any case, there are other uncertainties that cannot be analyzed in terms of mathematical probabilities.

One response to future uncertainty is to speculate and try to position one’s portfolio to take advantage of one possible outcome or another. The risk in taking that approach, apart from getting it wrong, is that we can end up acting on stale news or paying a premium to take advantage of news that is already in the price of a given security.

Another response is to stay highly diversified and to use the information in market prices to stay focused on dimensions of expected return.

This latter response doesn’t require speculation, forecasts, or second-guessing the market. It just requires an understanding of what we can and cannot control. So while we can’t control the future, we can control the structure of our portfolios, we can ensure we are broadly diversified, we can manage fees and taxes, and we can regularly rebalance to ensure the risk allocation stays within our chosen parameters.

Yes, the future is unknowable, and how it unfolds has differing implications for each of us, depending on our circumstances and needs.

While we cannot prepare the future for our portfolios, we can still strive to prepare our portfolios for the future.

Surprise! No Selloff in 2013

Written by Weston Wellington.

The unusually strong performance of US stocks in 2013 was a welcome surprise for investors who are following a simple buy-and-hold strategy and a source of exasperation for many professionals caught flatfooted by the steady rise in share prices.

It was the best year for the S&P 500 Index since 1997, with a total return in excess of 32%. The size and value dimensions were even more rewarding: 2013 was the best calendar year since inception for the DFA U.S. Large Cap Value Portfolio, while the DFA U.S. Micro Cap Portfolio had its second-best performance in 32 years of operation.

To some experts, it wasn’t supposed to look like this. A Barron’s cover story appearing in November 2012 warned investors to “get ready for the recession of 2013.” The title of a Time article on the outlook for financial markets that same month shouted, “Why Stocks Are Dead” in oversize type. A prominent economic forecaster who predicted the downturn in 2008 suggested that four elements—stagnating US economic growth, the European debt crisis, a slump in emerging markets, and military conflict in the Middle East—could combine and lead to a “superstorm.”

Another prognosticator—and longtime Forbes columnist—ticked off a long list of worries, including a new wave of housing foreclosures, persistent government deficits, weak consumer spending, high unemployment, and unsustainable corporate profit margins. His prediction for 2013: “the S&P 500 Index drops to 800, a 42% decline.”  Others fretted about a deepening slump in China that could drag the rest of the world down with it.

Detroit’s bankruptcy filing in July—the largest American city to do so—and the acrimonious debate over public finances in many cities and states suggested to some that a tectonic shift in municipal finance was underway with worrisome consequences.  One prominent Wall Street researcher observed that “the aftershocks of the largest municipal bankruptcy in US history will be staggering, and Detroit will set important precedents.”

Individual and professional investors alike braced themselves throughout the year for a sharp selloff that never materialized. At times, the perverse reaction to rising prices was not delight but apprehension of an even steeper decline to come. On March 5, 2013, for example, the Dow Jones Industrial Average finally eclipsed its previous record of 14164.53, set in October 2007. But the Financial Times reported that the prevailing mood among veteran New York Stock Exchange floor traders was “more anxious than joyful.”

Month after month, a Greek chorus of financial journalists recycled the same arguments we have heard regularly for the past several years: Economic growth is well below average, stocks are expensive relative to earnings, corporate profit margins are historically high and can only come down, earnings growth is too weak, asset prices have been artificially inflated by an expansive monetary policy, and so on. A sample of headlines that might have unsettled investors appears below.

January 12 “Rebirth of Equities Ain’t Necessarily So,” Financial Times
February 8 “Scant Pickup in Economic Growth Seen for 2013,” Wall Street Journal
March 7 “Stock Markets Defy Economic Woes,” Financial Times
April 2 “Lesser Expectations: Earnings Hopes Dim for First Quarter,” USA Today
May 18 “Stock Market Optimism on This Scale Hard to Explain,” Financial Times
July 7 “As Investors Rush in, Stocks Are Sending Warning Signals,” Wall Street Journal
August 24 “Lofty Profit Margins Hint at Pain to Come for U.S. Shares,” Wall Street Journal
September 18 “Profits Boost Needed for Wall Street’s Equities Run,” Michael Mackenzie, Financial Times
October 7 “Get Ready For a Drop in Stock Prices,” Shefali Anand, Wall Street Journal
November 16 “Is This a Bubble?” Joe Light, Wall Street Journal

With so many economic hobgoblins to frighten them, many investors found it easy to dismiss more positive developments as unsustainable or irrelevant. Auto sales, for example, have been surprisingly strong in recent years, but investors could find plausible reasons for caution in 2013. A New York Times financial reporter observed, “After steady increases for decades, Americans are driving less. … Walkable cities are growing faster than suburbs. And wherever people happen to move, they are buying smaller, more fuel-efficient cars. … All this means that autos—one of the biggest industries in the United States—will not soon regain the explosive growth of the early 2000s.” 

Some Americans are indeed buying more fuel-efficient cars; electric-only Tesla luxury sedans are popping up in driveways in tony neighborhoods across the country. But many other Americans are eagerly signing contracts for powerful full-size pickup trucks; light-duty truck sales were up roughly 20% through November, and the Ford F-150 continues to be the best-selling vehicle in America by a substantial margin. Last year turned out to be a rewarding one for shareholders of most auto manufacturers and suppliers as well.

Selected Automotive Stocks: 1-Year Total Return as of December 31, 2013

Tesla Motors (TSLA) 344.14%
Visteon (VC) 74.32%
Johnson Controls (JCI) 69.84%
Magna Intl (MGA) 66.61%
General Motors (GM) 41.76%
Paccar (PCAR) 34.64%
Cummins (CMI) 32.18%
Ford Motor (F) 22.24%

Source: Morningstar (www.morningstar.com), accessed January 2, 2014

What can investors learn from this year’s market behavior? Most of us accept the idea that predicting the future is difficult. And predicting how other investors will respond to unpredictable events is harder still. But, for some of us, the temptation to engage in such efforts is irresistible. If only we could do so, we could be so much wealthier, have the satisfaction of outwitting other clever market participants, and make ourselves more attractive to members of the opposite sex. But results from this past year tell us we should be skeptical of our ability—or anyone else’s—to do this well enough to outperform a simple buy-and-hold strategy. When investors are studying the long-run record of US stock market returns several years from now, we suspect many of them will find it difficult to recall exactly what it was that they were so worried about and discouraged them from pursuing the capital market rewards that were there for the taking.   

 

 

References

“Are We Headed for a Recession?” Barron’s, November 12, 2012. Rana Foroohar, “Why Stocks Are Dead and Bonds Are Deader,” Time, November 26, 2012. “Roubini: Perfect Storm or Not, 2013 Will Be Bumpy, Risky,” Moneynews, November 18, 2012. A. Gary Shilling, “Prepare for a Market Plunge,” Forbes, January 21, 2013. Meredith Whitney, “Detroit May Start a Wave of Municipal Bankruptcies,” Financial Times,  July 24, 2013. Adam Davidson, “What’s it Going to Be, 2013?,”  New York Times, January 6, 2013.

YOUR YEAR-END FINANCIAL CHECKLIST

Written by Gerald Gasber, CFP®, CIMA®.

Seven aspects of your financial life to review as the year draws to a close.

Investments

Review your investment strategy – make sure it’s in keeping with your current goals. Look over your portfolio positions and revisit your asset allocation.

Retirement

Take a look at your overall retirement strategy. Does it (still) make sense? If applicable, take your RMD (required minimum distribution) from your traditional IRA. Take a look at and/or max out contributions to IRAs, 401(k)s. Consider maxing out catch-up contributions, if applicable. Finally, consider Roth IRA conversion scenarios.

Taxes

Search for possible credits and/or deductions before the year comes to a close. Have a qualified tax professional put together a year-end projection, including Alternative Minimum Tax (AMT). Review appreciated property sales and both realized and unrealized losses and gains. Take a look back at last year’s loss carry-forwards. If you’ve sold securities, gather cost-basis information. Look for any transactions that could potentially enhance your circumstances.

Gifts and/or Contributions

Plan charitable contributions or contributions to education accounts, and make any desired cash gifts to family members. Review and fund trusts, as applicable.

Insurance

Are your policies and beneficiaries up to date? Review costs, beneficiaries, and any and all life changes that may affect your insurance needs.

Personal Changes

This year, did you …

    ... get married or divorced?

     ... move or change jobs?

     ... buy a home or business?

     ... have (or adopt) a child?

     ... receive an inheritance or gift?

     ... see a severe illness or ailment affect a family member?

     ... lose a family member?

     ... discover that your parent(s) would need assisted living?

Birthday Milestones

Did you turn 70½ this year? If so, you must now take Required Minimum Distributions (RMDs) from your IRA(s).

Did you turn 65 this year? If so, you’re now eligible to apply for Medicare.

Did you turn 62 this year? If so, you’re now eligible to apply for Social Security benefits.  But that doesn't mean you should!

Did you turn 59½ this year? If so, you may take IRA distributions without penalty.

Did you turn 55 this year? If so, and you retired during this year, you may now take distributions from your 401(k) account without penalty.

Did you turn 50 this year? If so, “catch-up” contributions may now be made to IRAs (and certain qualified retirement plans).

The end of the year is a key time to review your financial “health” and well-being.

If you feel you need to address any of the items above, please feel free to give us a call.

 

This Secret Agenda Hurts Your Returns

Written by Daniel Solin.

If you follow the financial media regularly, you will find daily predictions about the direction of the markets. Breakout, a daily blog on Yahoo Finance’s website, is typical of what passes for financial information. On September 6, Breakout’s Jeff Macke featured Mike Jackson, the CEO of AutoNation, as his guest. Jackson opined that the economy “has moved into a self-sustaining recovery.” He may or may not be correct in that assessment, but relying on his views or the views of others claiming predictive powers is more akin to gambling than investing.

Macke’s program is no worse than what is dispensed by many of his colleagues in the media. The format is familiar to all of us: Intelligent people in positions of power and influence make rational-sounding statements about the economy, the direction of the market or the merit of a particular stock or fund. What’s missing is any data indicating that their views are worthy of consideration, based on a history of accurate past predictions or demonstration of predictive skill (as contrasted with luck).

There is ample evidence to the contrary. In a paper published in July 2010, three finance professors from Duke University and Ohio State University published the results of an extensive survey they performed. Each quarter from March 2001 to February 2010, they surveyed “top U.S. financial executives.” They asked them to predict one- and 10-year stock market returns and also for their predictions of best- and worst-case outcomes. The data they gathered aggregated 11,600 S&P 500 forecasts.

You would think the accumulated expertise of these executives would permit them to make fairly accurate predictions about a commonly used index such as the S&P 500. The opposite was true. The authors of the study found no correlation between the estimates of these top financial executives and the actual value of the index. In fact, the correlation was negative. When they predicted the index would decline, it was modestly more likely it would go up.

Nobel Laureate Daniel Kahneman commented on this study in his book, "Thinking, Fast and Slow", noting, “These findings are not surprising. The truly bad news is that the CFOs did not appear to know that their forecasts were worthless.”

Since the data is overwhelming that predictions are basically “worthless,” why do investors continue to pay attention to them, often to their financial detriment? Kahneman provides this answer: "Facts that challenge such basic assumptions – and thereby threaten people’s livelihood and self-esteem – are simply not absorbed. The mind does not digest them."

If investors accepted the fact that the predictive views of financial “experts” were “worthless,” the ramifications would be profound. Much of the financial media would cease to exist. Brokers would go out of business because clients would view their advice through the prism provided by sound academic studies and the views of scholars such as Kahneman. This result – threatening the livelihood and self-esteem of powerful segments of our society – is simply not going to happen.

While much of the financial media and many brokers are driven by this secret agenda to maintain their livelihoods, you should ignore their musings and base your investing decisions on reliable, peer-reviewed data.