Download Q3 2013 - Sovereign Wealth Advisors

VIEWPOINT
A Review of the Past and a Look Toward the Future
A review of the Second Quarter
Equities gain, everything else falls in the Second Quarter
The second quarter was a tale of two halves, the first half most
everything went up, and the second half most everything fell. This line was
reached in May when the Fed announced that they would begin to taper
their bond purchases earlier than investors had expected. This
announcement while not new, sparked interest rates to move higher, and saw
equities and commodities move downward.
Most US Stock Indices reached all-time highs during the second quarter.
US stocks ended the quarter up, extending gains for the year. International
stocks fell slightly as the US Dollar negatively impacted returns. Money
continued to flow into stocks; increased dividends and continued share
repurchases from companies were alluring to investors and supportive of
share prices. Emerging markets fell -9% during the quarter, as slowing
growth, higher inflation, lower commodity prices and political instability
hurt the emerging markets.
Fixed income had its worst quarter since 1994. Nearly every type of bond
fell in price, and some bonds fell double-digits. The Fed’s communication
coupled with investors running for the doors at the same time, left the asset
class down for the quarter and year. International bonds were primarily
negative as the US Dollar rose during the quarter.
REIT’s fell as investors sold investments that are sensitive to rising
interest rates. REITs were up nearly 12% for the quarter until the Fed
announcement, and ended the quarter down -2.2%.
Commodities lost nearly -10%. Worries about China’s growth and a lack
of inflation have spooked investors. Gold fell -23% during the quarter.
Third Quarter, 2013
Doug Hockersmith, CFA
Chief Investment Officer
Mortgage Rates
Mortgage rates have increased
significantly over the past
three months. This is the
result of the market setting
rates higher for longer dated
bonds. A 30 year mortgage is
normally set off the 10 Year
Treasury yield. Since the 10
Year Treasury has risen 1%, it
is understandable that 30 year
mortgage rates also rose
around 1%. We feel that bond
rates are likely to increase
forward-going. Now is a good
time to originate a mortgage,
or refinance a higher rate fixed
or
an
adjustable
rate
mortgage. Adjustable rate
mortgages are often set off
LIBOR or the 1 Year Treasury.
These rates are likely to stay
low for another year or two,
but then should rise.
Thank you – Sovereign Wealth
Advisors
Bellevue: 425-289-4222
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Four significant issues for the
Third Quarter
Interest rates on the rise. How quickly and how
high will they go?
• What is the Fed communicating and how will it
impact the economy and investments?
• Interest rates on the rise. How quickly and how
high will they go?
• What happened to the Other asset classes in the
second quarter and what do we anticipate in the
second half of the year?
• The Fundamental discussion on the US Stock
market.
Supply and demand are likely to be key in interest
rates increasing. Since 2007, investors have purchased
$1.5 trillion dollars of bonds, while buying $333 billion
of stocks. Over this time period the amount of debt
issued has increased dramatically, while the number of
shares of companies outstanding has decreased. If
you look at the needs of government, local and
federal, both continue to operate with deficits. These
deficits need to be funded by issuing more debt. So
the bond market could face more supply and
What is the Fed communicating and how will it potentially less demand.
impact the economy and investments?
Since the crises began in 2008, the Federal Reserve
has done just about everything possible to help support
the economy through monetary stimulus. This was
accomplished initially by lowering short-term interest
rates to zero. Given the magnitude of the economic
crisis, the Fed felt it needed to do more and came up
with the strategy of Quantitative Easing (QE).
Through QE, the Fed became active participants in the
bond market by buying US treasuries and agency
mortgage bonds. The Fed can control short-term
interest rates but the markets determine what the
intermediate and long-term rates should be. The Fed’s
bond buying has created artificial demand, which
caused interest rates to be lower than they normally
would be. If you remove the Fed as an active
participant in the bond market, rates from 5 to 30 years
out are probably 1% to 2% lower than what history
says they should be.
On May 22, 2013 the Fed chairman communicated
that if the economy continues to improve, they would
taper the bond buying and eventually conclude QE.
Following this announcement the yield on the 10 year
increased over 50% to 2.66%. The jump in interest
rates resulted in prices declining in the bond market.
The Barclay’s Aggregate closed the quarter down
-2.3%. We will continue to follow Fed communications
closely and position your portfolio accordingly.
So how high can interest rates go? This is a
question much like how far can the stock market drop,
much more than you’d expect. A worry we have on
longer-term bonds is that if interest rates start moving
higher, where do the buyers come in. It depends on
what inflation does, what the US Dollar does, and how
investors feel. If inflation goes higher, the US Dollar
weakens, and investors fear bonds, then you will see
rates move dramatically higher.
So when will rates rise? Much of the when will be
determined by investor sentiment. When you play
musical chairs, no one wants to not have a seat when
the music stops. If investors begin to see losses on
their bonds, and the future appears to have bonds
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falling in value, many investors will sell. The selling
then creates higher rates, which creates more losses,
which leads to more selling. This cycle is a probable
outcome. The bond market will also have to deal
with new supply. If the US Government goes to the
market to sell bonds, it may need to issue them at
higher and higher interest rates to entice investors to
buy them. If the new issues sold are at higher
interest rates than current levels, it causes the value
of all the bonds to fall. On the plus side, the increase
in rates will allow investors to earn a higher yield on
new purchases of fixed income.
What happened to the Other asset classes in the
second quarter and what do we anticipate in the
second half of the year?
Investment returns in what we consider
Alternatives did very poorly in the past quarter.
Investments like commodities, emerging market
bonds and stocks, Treasury protected securities
(TIPS), and non US Dollar currencies all fell during
the quarter, while US stocks went up. So why did
these investments perform in this manner? The
primary reason is inflation. These types of
investments do well in periods of rising inflation.
The past quarter displayed low economic growth and
low inflation.
When we build investment portfolios, one of the key
characteristics is the investments correlation to the
other asset classes in the portfolio. Investments with
low or negative correlations are attractive from an
asset allocation viewpoint. A low or negative
correlation means that if one investment moves north,
then the other investments may move in the opposite
direction or slightly in the same direction. If all your
investments moved the same way at the same time,
there would be no reason to own more than one
investment.
So what do we foresee in the near future? Normally
when you see a significant drop or dramatic relative
underperformance in a quarter, in the next quarter; the
investments that underperformed often will recover
some or all of the loss. While you own these types of
investments because of the diversification they
provide, they also have performed well in the past
when inflation was rising. Inflation is something we
still are very concerned about. Given the amount of
debt that the US Government has, and the perpetual
deficits, the outlook for future inflation is a worry.
Inflation is known as the silent killer, and we want to
protect your portfolios against a decline in purchasing
power.
While Alternative assets will have quarters like the
second quarter, they may also shine in periods where
US bonds or US stocks are struggling.
The Fundamental argument on the US Stock
market.
With US stocks reaching all-time highs, we feel that
a fundamental review is warranted. When we analyze
something through fundamental analysis, we are
looking at the metrics of the investment, and how
those metrics stand up relative to its own history and
relative to other investments. We then look forward at
how the investment will fair in the upcoming
environment. Finally we try to take into consideration
anything else that might have an impact to the
investment.
When reviewing the price to earnings (P/E), price to
sales (P/S), price to cash flow (P/CF), and book value,
US stocks trade slightly below their historical averages
on all the above metrics. When you compare the yield
(dividend / price) on stocks to the yield on the 10 year
US Treasury, historically you have had a much wider
discount then the current relationship between the
two.
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On the negative side, profit margins are at all-time
highs; many believe that earnings will begin to fall.
Another issue is that sales revenue has been flat and
the little growth in earnings has been primarily from
cost cutting and share buybacks. Lastly some will make
the case that valuations are not cheap if you use the
Shiller PE, which averages the past 10 years earnings.
We feel that from a fundamental viewpoint, US
Stocks remain an attractive investment for the longterm.
How We Are Positioning Your Portfolio?
Reviewing the balance sheets for US stocks, it
looks about as good as it ever has. US corporations
have high levels of cash, low levels of debt, and the
cost of the debt is financed at very low levels. With
profits being at record highs, companies have been
raising dividends and buying back their stock. The
forward outlook is positive for additional dividend
increases and stock buybacks as companies will be
able to use future earnings to fund these programs.
Fixed Income
We are nearly at our maximum underweight towards
US fixed income. The return US fixed income offers
versus the potential risk is currently not very favorable.
Bonds are part of your portfolio because they offer
capital preservation and income. We have identified a
few ways to maximize these characteristics. We
recommend a significant allocation to floating rate
bonds. These bonds offer current yields that exceed
intermediate and long-term bonds, and have the ability
to increase their yield as rates rise.
Another positive factor fundamentally for US
stocks is money flows. US investors remain under
invested in US stocks and have finally begun to buy.
This reverses a trend that have lasted for more than 5
years. US stocks are also benefiting from foreign
purchasers. With companies buying back stock, the
continuation of mergers and acquisitions, and a
limited amount of new initial public offerings
(IPO’s); the demand for stock is likely to exceed the
supply. This should translate into higher stock prices
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We also recommend that you have bond funds that
are not constrained by having to follow the Barclays
Aggregate Index. The Barclays Aggregate Index is
primarily US Government and US Corporate Bonds,
that have investment credit ratings and average
maturities around 5 years. Given how quickly things
are changing, we want to allow your fund managers
flexibility in navigating these volatile times.
The second quarter was the first time in five years
that investors removed money from US bond funds.
We think that this will be the start of a new trend. As
investors experience losses on their bonds, many will
sell. Many investors that have shunned US Stocks
may move from bonds to stocks, other will likely
park it in cash. The bull market for US Bonds that
begun in 1980, appears to have ended in the second
quarter.
We are recommending a small overweight to
international bonds. Currently yields are higher
internationally and our managers have the
opportunity to invest in currencies that are stronger
than the US Dollar. The emerging markets remain
attractive and are owned by both your international,
core bond, and opportunistic bond funds.
Equities
Tactically we are recommending a slight overweight
to Large Cap domestic equities. We feel a focus on
dividend paying stocks remains an attractive risk
adjusted way to invest. Even though the S&P 500
continues to march higher and is trading at all-time
highs, it still remains attractive. The S&P 500
constituents continue to grow earnings, continue to
increase dividends and have been buying back
significant amounts of their stock.
The graph shows yield of the 10 Year US Treasury, the
yield of the S&P 500, and the difference between the
two which is referred to as the spread. Since 1965, the
only time the yield on the S&P 500 has exceeded the
10 year US Treasury is over the past year. We consider
this a great metric in being able to evaluate the relative
attractiveness of stocks verses bonds. To us this graph
illustrates relative value; bonds are more expensive
than stocks. We are also tilting your Large Cap equity
allocation towards the Growth style. While most
equities are trading at valuations lower than historical
averages, Growth trades at a wider discount than
Value.
We continue to recommend a slight overweighting
to International Equities. The MSCI EAFE failed to
keep up with US stocks once again in the second
quarter. With Europe showing signs of improvement
and stimulus from the Bank of Japan, the
fundamentals are improving for owning stocks outside
the US.
Valuations for MSCI EAFE remain very attractive.
The PE on the MSCI EAFE is less than the US and
less than historical levels. The yield on the MSCI
EAFE is 3.4%, which is 60% higher than the S&P
500. While US equities are creating new all-time highs,
the MSCI EAFE would need to appreciate 50% to be
back at its highs set in 2007.
The Emerging markets had another poor quarter
losing around -9%. The Emerging markets are trading
well below their fundamental averages. It is projected
that the Emerging markets economies will grow
quicker than the developed markets, yet the Emerging
markets have a PE that is 25% less than the MSCI
EAFE.
Alternatives
We continue to recommend a slight underweight to
REIT’s. REIT’s have lost some luster as interest rates
began to rise. As interest rates increase, the high
dividend yield on REIT’s become less attractive to
investors seeking high current income. When you look
at the valuations and yields on REIT’s, they seem
expensive to their historical averages. This is illustrated
on the following page.
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REIT Industry Dividend Yields
We are recommending a slight underweight to
Commodities. Commodities performed poorly this
quarter, ending down nearly -10%. Gold and precious
metals were the worst performing commodities. In an
inflationary environment, commodities should
perform well.
Philosophy
It is important to note that given such volatile and
quickly evolving times, our current tactical strategy as
outlined above may require intra-quarter modification.
We remain committed to helping you achieve your
investment objectives by creating investment
portfolios that align with your risk and return
objectives. If you would like to review your asset
allocation changes or would like additional
information on our other asset allocation strategies,
please feel free to contact us at your convenience.
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