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10 .5 ISSUE 13.2 Harvey’s Investment Review June 2013 SECOND QUARTER 2013 STATISTICS Gross Domestic Product (GDP) 4th Qtr 2012 +0.4% 1st Qtr 2013 +1.8% Consumer Price Index (CPI) / Core Apr: -0.1% May: 0.2% Oil (light crude) June 30: $96.56 bbl 3-Month T-bill: 0.02% 10-year T-bond: 2.52% (June 30) Gold May 31: $1,394.50/oz Jun 30: $1,235.00/oz $/Euro at 1.3036 Yen/$ at 98.476 (June 30) Unemployment: Apr: 7.5% May: 7.6% **Sources provided on the Explanation Page. Please note that past performance is no guarantee of future results Harvey A. Wartosky A Financial Representative offering advisory services and securities through Lincoln Investment Planning, Inc. Tel: 800 251 1995 A fixed income bubble is inflating that could appreciably deteriorate portfolio values. Retail investors (you) traditionally use bonds to provide income and assure portfolio safety. Right now, the Federal funds rate is only 0.25% and the 30-day Treasury Bill is at a multi-generation low. With current inflation at less than 2%, investors holding certificates of deposit, money market accounts and other short-term fixed income instruments are actually losing real money. Income is no longer a good reason to own bonds. Usually bonds are a buffer against the brunt of a declining stock market, because the price of bonds tends to rise when the price of stocks declines. But, this is not a hard and fast rule, because sometimes bonds have suffered extreme losses and have contributed to a substantial loss of portfolio value. Institutions are the culprits for bond market debacles, since financial behemoths seek short-term capital growth. They make risky bets on the direction of interest rates and sometimes earn twenty times their original capital outlay. A bad bet can lead to losses and bankruptcy. The battlefield of financial wagering is littered with the corpses of failed institutions like Bear Stearns, Countrywide Credit, Long-Term Capital Management and all the banks in Cyprus. A cascade of failures can even crash markets as in 2008 and even upset the entire financial system. Many retail investors saving for retirement or seeking modest capital growth harbor the false notion that bonds are always a safe investment. Nothing could be further from the truth. The following is a list of fixed income calamities during the past 100 years triggered by the confluence of inflation, declining credit quality, excessive leveraging and out-of-control speculation: 1. When Germany went off the gold standard in 1914 to finance WWI, interest rates began to rise and never stopped. In the 1920s hyper-inflation destroyed 90% of the value of German bonds in a matter of months. Valuable investments turned into massive liabilities. 2. From 1955-1959, during the "Eisenhower Bond Recession," the post-WWII economy boomed from low taxes, a balanced budget and public spending. The stock market rose during this period, but the bond market declined 4 times between 1955-1959. Over this 5-year period long-term Treasury bonds suffered an annualized loss of -8.11%. The culprit was the explosion of consumer debt fueled by the introduction of credit cards. Buying on credit may have stimulated demand and retail consumption, but a massive buildup of debt took its toll on the bond market. 3. In 1969 there was rampant inflation in the US, propelled, in part, by the Vietnam War, race riots and the beginning of a 14-year long stagnant stock market. That year the average long-term Treasury bond lost a devastating -18.1% of its value and corporate bonds lost -6.8%. Investors who bought bonds for income were crushed by the loss of capital value. Time Magazine estimated that "The value of long-term Treasuries dropped from $1,000 to $714". 4. Fortune Magazine called 1994 the year of "The Bond Market Massacre" when over $1 trillion disappeared from fixed income markets. The trigger for the sell-off was a modest 0.25% hike of the Federal Funds rate to stifle inflation unleashed by economic growth. During 1994, the average long-term Treasury bond declined by 11.1%. The villains were fund managers who ignored the consequences of a Fed tightening of interest rates. Managers had become inebriated by the drop in rates from 8% in 1992 to 3% in 1994 to juice GDP growth and lower unemployment. Today’s economic environment and Fed policy are strikingly similar to Pre-1994 when the Fed dropped rates to near zero, also in an attempt to stimulate the economy and reduce unemployment. The combination of lowering rates to provide liquidity and then raising rates to curb inflation proved to be a mortal blow to the bond market in 1994. Some Fed governors at the Federal Open Market Committee (FOMC) meeting in February warned that even a small increase in rates would tank the fixed income market. They were right. Today's economic environment mirrors those of previous years, particularly 1994. This similarity is instructive, because it provides insights to investors about how to allocate bonds in their portfolios. For the moment, bonds yield close to nothing, but they remain relatively safe investments. The case for an imminent explosion of the inflating bubble in bonds is weak right now, since GDP growth is anemic, unemployment is high and inflation is low. Today, the Fed is pumping $85 billion each month into the economy to jump-start GDP growth, and they intend to keep rates near zero until 2015 to encourage investors to sell low-yielding bonds. Bonds may be in a bubble that is just beginning to inflate. Before the Fed begins to raise rates and bond prices begin to tick down, investors need to determine how much cash they plan to withdraw from their portfolio each year and how much volatility they can withstand. Then they can begin to reduce the fixed income allocation of their portfolios. Benjamin Franklin said, "Great haste makes great waste," but he also said, "You may delay, but time will not." The bond time bomb is ticking. ISSUE 13.2 Harvey’s Investment Review June 2013 S&P 500: is a value-weighted index of 500 widely held stocks often used as a proxy for the stock market. The S&P 500 index includes 500 of the largest stocks (in terms of stock market value) in the United States and represents a sample of top companies in leading industries in the U.S. economy. Dow Jones Industrial Average: is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the NASDAQ. The DJIA was invented by Charles Dow back in 1896. New York Stock Exchange (NYSE): is the world’s largest stock exchange by market capitalization (with listed companies at $12.25 trillion as of May 2010), located on Wall Street in lower Manhattan, New York City, USA. Gross Domestic Product (GDP): is a measure of output from U.S. factories and related consumption in the United States. It does not include products made by U.S. companies in foreign markets. Consumer Price Index (CPI): measures prices of a fixed basket of goods bought by a typical consumer, it is widely used as a cost-of-living benchmark and uses January 1982 as the base year. Oil (light crude): Crude oil is the world’s most actively traded commodity. Oil is considered light if it has a low density and low wax content and may be considered sweet if it contains relatively little sulfur. Light crude oil is more desirable than heavy oil since it produces a higher yield of gasoline. Sweet oil commands a higher price than sour oil because it has fewer environmental problems and requires less refining to meet consumption standards. Treasury bills (T-bills): are short-term securities with maturities of one year or less issued at a discount from face value. Treasury bills are the primary instrument used by the Federal Reserve in its regulation of money supply through open market operations. Sources and ideas for information in this newsletter: The Economist, The Wall Street Journal, The Financial Times, Investor Business Daily, Bloomberg, Market Watch, Reuters, US government web sites, Morningstar, CNBC, James Surowicki, Niall Ferguson, Heather Wagner, BNP, private foundation reports, Peter Bernstein, Goldman Sachs Research and Ned Davis. *Sources of Statistics listed on front page: Statistic GDP CPI Oil T-bill & T-bond Website name Bureau of Econ. Analysis US Dept. of Labor CNN Money US Dept. of the Treasury URL Gold Exchange Rates Kitco Bullion Dealers Yahoo! Finance http://www.kitco.com/ Unemployment US Dept. of Labor http://data.bls.gov/timeseries/LNS14000000 http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm http://data.bls.gov/timeseries/CUUR0000SA0?output_view=pct_1mth http://money.cnn.com/data/commodities/ http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.as px?data=yield http://finance.yahoo.com/currency-converter/?amt=1&from=USD&to=JPY&submit=Convert #from=EUR;to=USD; amt=1 Advisory Service and Securities offered through Lincoln Investment Planning, Inc. Associates of The Wartosky Group, LLC are financial representatives of Lincoln Investment Planning, Inc. Lincoln Investment Planning, Inc. is a Registered Investment Advisor, Broker Dealer, Member FINRA/SIPC. The Wartosky Group, LLC and Lincoln Investment are independently owned and each is responsible for its own business. Lincoln Investment supervising office: 218 Glenside Avenue, Wyncote, PA 19095 (800) 242-1421. Harvey A. Wartosky A Financial Representative offering advisory services and securities through Lincoln Investment Planning, Inc. The Wartosky Group, LLC. 84 State Street, Boston, MA 02109 Phone: (800) 251-1995, Fax: (617) 227-1993