Wednesday, June 5, 2013

Interest Rates Start Moving Up – International Markets Falter, but U.S. Stocks Continue to Trend Higher during May

From the Desk of Joe Rollins

We knew the day that interest rates would start rising would come eventually. Due to mixed signals coming from the Federal Reserve, that finally started to happen during the month of May. The very important 10-year Treasury bond has moved up from approximately 1.5% to 2.1% in recent weeks. And while 2.1% is still historically an extraordinarily low rate, this move has been fairly dramatic considering the relatively short period of time that it has occurred.

Interestingly, there’s little reason for this quick increase in interest rates other than the perception that, at some point soon, the Fed will reduce its accelerated buying of bonds in the open market. Also, the short-term traders believe that they must be ahead of every trend (even if it’s a year in advance), and during May, the general presumption was that the Fed would sooner rather than later reduce their support of the bond market. I don’t believe that concept for a second, but as the old saying goes, “Don’t fight the Fed!”

May was another very good month for the stock market. As every month in 2013 has proven thus far, if you’re invested in quality mutual funds, then it’s highly likely you’ll make a profit regardless of the underlying economic news. The S&P Index of 500 Stocks was up a very satisfying 2.3% for May, and it is now up 15.4% for the year. The NASDAQ Composite also turned in an excellent performance, up 4% for the month and 15% for the year. The Dow Jones Industrial Average was up 2.1% for the month and 16.5% for the year. Even the small-cap Russell 2000 Index was up 4.1% for the month and 16.6% for the year. It’s remarkable that all four of the major market indices are up almost the same percentage for the year, and the range from 15% to 16.6% for four broadly-based indices shows how strong the equity markets have performed thus far in 2013.

The performances of the other asset classes in the financial world were not as satisfactory. Because of the increase in interest rates, virtually all bond funds suffered a decline during May. In fact, the aggregate of all bond funds declined 1.9% for the month. Even the otherwise reliable high-yield bond funds had marginal losses for the month. While you would certainly expect negative returns when interest rates move up, I am not of the opinion that bonds will continue to suffer losses for the rest of the year. Rather, I believe the increase in interest rates that we saw in May was a market phenomenon that, at its core, had nothing to do with the underlying economics. We’ll continue observing these movements over the coming months to see if a negative trend continues.

More concerning is the performance of the international markets, which almost exclusively suffered losses during May. The high-flying Japanese market took a major hit and was down significantly during the month. Interestingly, the only major international market to have gains during May was the Chinese market, and its economy probably spooked the sell-off in the first place. There is no question that China is slowing, but almost all international markets are teetering on break-even or negative GDP.

Unfortunately, the European economies just can’t seem to get out of their own way. With their generations of big government and bloated public works systems, they just can’t seem to figure out how to change the economy from government-based to private-based. Hopefully, Europe is slowly but surely catching on and in the coming months their economies will stabilize.

During a conversation with a client the other day, it became apparent that the returns for the stock market are often misperceived by average investors. This particular client proclaimed that the stock market’s returns over the last decade were fooling investors about long-term performance. He assured me that bonds had outperformed stocks over the last decade, and he was even willing to make a wager on that fact. I didn’t want to be too argumentative so I accepted his presumption, although I was relatively sure he was incorrect.

After reviewing the facts, I found his information to be totally flawed. Over the last 10 years, the S&P 500 has averaged an annual return of 7.6%; the NASDAQ has averaged 9%; the DJIA has average 8.2%; the Russell 2000 has averaged 9.8%; and the Barclay’s Aggregate Bond Index has averaged only 4.4%. As you can see, bonds have, on average, returned less than half of the broad major market indices. The media’s constant pounding of some impending downturn in the market has convinced investors to believe information that is not supported by reality.

The increase in interest rates during May created a strange and unusual investment environment. For some reason, the momentum traders believed that the increase in interest rates would somehow affect the excellent performance that high-yield dividend stocks have enjoyed for the last several years. How anyone could logically assume a 2.1% Treasury could compete with a utility stock paying 4.5% continues to be a mystery to me. However, traders tend to move in waves in the same direction at the same time.

During the month, there was a fairly significant sell-off of utility and high dividend stocks. As a group, the telecom and utilities index lost 6.9% for the month. It defies imagination that anyone would sell a high quality utility stock to purchase a Treasury yield of 2.1%, but perhaps I’m wrong. I believe you’ll see this sector recover over the next few months as the realization sets in that higher interest rates are not in the offering. Keep in mind that CDs continue to earn almost zero…

As we enter into the dreadful investing months of summer, I find myself answering the almost daily question of where we stand today. Frankly, the economy seems to be going nowhere – which is not all bad. While the housing sector is certainly improving and there are other positive signs for the economy, it simply doesn’t seem to be improving very quickly. As strange as that seems, that’s actually a positive sign for stock market investing. As long as the economy continues to be flat, it’s highly unlikely that you’ll see the Fed stop its massive stimulus initiative. By virtue of a slow economy, I think you’ll continue to see the Federal Reserve expand the monetary base, which is nothing but positive for stocks.

Of course, there are many potential concerns. We can all fret over the huge tax increases all of us will suffer at the beginning of 2014. It’s now being reported that medical insurance rates will increase significantly in January to accommodate the Obamacare provisions. Additionally, there are potential repercussions from the huge new taxes being instituted on the wealthy, which I fear most taxpayers don’t realize. The European economy continues to putter along and Asia is clearly trending down, even though it’s still quite posi¬¬¬¬tive. I could make a long list of things for us to worry about, but I would also be compelled to tell you not to worry just yet.

As I’ve often mentioned, the major positive investing component continues to be the support of the stock market through higher earnings and low interest rates. Even with the increase in interest rates, the S&P 500 dividend yield is still higher than the interest rate earned on the 10-year Treasury. Rarely has this high dividend rate extended over such a long period of time (i.e., higher than the 10-year Treasury). Earnings continue to be excellent and even though the rate of increase is decelerating, it continues to go up, not down.

For the time being, everything appears to be stable from an investment standpoint. As you know, anything can change overnight. It wouldn’t be unexpected to see a 10% decline in the market at any time for no good reason, but with almost no better alternatives for investing money, I would be surprised to see a major decline for the rest of 2013. In fact, corporate earnings appear to be on pace to increase in 2014, which is always a positive.

There’s been much publicity regarding the projected decline in the federal deficit over the next several years. I wonder how much of those projections were tainted by the fact that many taxpayers pre-paid taxes in 2012 to avoid the huge increases in taxes in 2013 and 2014. If these projections were based on the analysis that these tax gains to the government would continue, then those projections couldn’t possibly be true. Unfortunately, the federal government continues to do absolutely nothing, and therefore, the huge deficits will continue. Congress may criticize sequestration as being inappropriate, ill-advised and misplaced. From my standpoint, it’s the only thing Congress has done right in a decade or so.

Now is an excellent time to visit with us and review your financial plan. And if you have cash sitting around earning nothing, what time could be better than now to consider investing that cash?

As always, the foregoing includes my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best regards,
Joe Rollins