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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 1 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 2 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. 3 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 4 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. 5 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. 6