MARKET UPDATE AND COMMENTARY
November 17, 2013
Just when you think Washington cannot get any more dysfunctional, our political leadership manages to find new ways to outdo themselves. Thankfully, the stock market’s collective view has been to watch warily but not lose focus on earnings and economic data that shows a slow, plodding economy continuing to grow. The Wall Street Journal reports that according to FactSet, of the 460 companies reporting earnings for the third quarter so far, 73% have exceeded their consensus earnings forecasts. Additionally, at Janet Yellen’s confirmation hearings this past week to succeed Ben Bernanke as Fed Chairman, she made clear that she would continue the Federal Reserve’s accommodative monetary policy for the time being. This relieved one of the immediate fears of investors that the Fed would begin drawing down the bond purchase program before the economy was strong enough to stand on its own.
Two full trading weeks into November, the Dow Jones Industrial Average (DJIA) has gained 2.7% for the month. The S&P 500 is up 2.4%, the Russell 2000 is up 1.5%, and the NASDAQ is up 1.7% over the same period. For the year, the DJIA is up 21.8%, the S&P 500 is up 26.1%, the Russell 2000 has gained 31.4%, and the NASDAQ leads the other indexes with a gain of 32.0%.
The dovish (favoring accommodative monetary policies) position taken by Ms. Yellen during her confirmation hearing helped bonds find some stability. Looking at changes to the 10-year US Treasury bond yield so far in 2013 (above), you can see where interest rates shot up in early May after Mr. Bernanke indicated he would begin tapering bond purchases in 2013. At the September Fed meeting, Bernanke suddenly changed his tune and signaled that tapering would not begin for some time causing interest rates to fall and the 10-year yield has remained within a range of 2.5% and 2.8% ever since. The Barclays US Aggregate Bond index has improved by 2% since mid-September although it still remains down 1.5% for the year.
YOU AND DURATION
I am going out on a limb and make a prediction.
Now everyone who has read my Market Update and Commentary since I began writing them some four years ago knows that I do not like making predictions. The reason is that predictions are nearly impossible to get right repeatedly. So while it may be fun to speculate about future events and outcomes, they rarely provide the basis for consistently sound investment decisions. However, today I am going to do it anyway and here it is: 98% of people find talk about bonds and bond theories boring! Yep, that’s it. With this prediction in mind, I am going to have a discussion with you about bond theory. Why? Because it is very important and many, many investors have a lot of money tied up in bonds. So consider yourselves forewarned and grab a cup of coffee or Red Bull before you read the next couple of paragraphs.
One of the most important concepts for investors to understand is that when interest rates go up, bond prices fall. This happens because as rates increase, a bond owner with a fixed-rate bond must reduce the value of their bond in order to attract buyers. If the bond owner has a bond paying 5% and yields for similar bonds is now 6%, why would a bond buyer purchase a 5% bond when they could get a 6% bond? The answer is they would not, so the bond owner drops the price of their bond until the effective yield to the buyer is 6%.
Therefore, bond owners realize that if interest rates go up, they are likely to lose principal. If they own one bond, the calculation to determine how much the bond’s value will fall as rates rise is relatively easy to determine. But what happens if the bond owner has many different bonds and they want to know the impact of rising interest rates on the overall value of their portfolio? This is where the concept of duration comes in.
Technically, duration is the measurement in years that it will take for the price of a bond to be repaid by internal cash flows (interest and ultimately principal). The longer the duration, the greater the risk of price volatility. Like many tools in finance, there are multiple types of duration calculations and they are all complex to determine. For most of us, the most important duration we need to be familiar with is modified duration which is designed to tell the investor how much principal they could expect to lose if interest rates rise by 1%. Modified duration can be found from many sources but is most readily available from Morningstar. If, for example, your bond investment has a duration of 4.5 years you could expect to lose about 4.5% of principal for every 1% rise in interest rates. Because bonds pay interest, those interest payments help offset the loss of principal in the bond portfolio. This last point is a key concept I want to you to come away with.
Although we have been in a 30-year bull market for bonds where interest rates have been falling since the early 1980’s, many bond managers (include me in this group) believe that interest rates will go up from the historic lows reached in the past year (1.4% in July 2012 for the 10-year Treasury). Interest rates, like most other economic data, do not rise or fall in one straight line; rather they go up and down in the overall directional move. The year 1994 is considered one of the most painful in terms of bond prices in the modern era. The 10-year US Treasury yield began 1994 at 5.75% and closed the year at 7.78%--a rise of 2.03%. A portfolio with a duration of 4.5 years would have lost about 9%. However, investors received interest payments over the year. Assuming for purpose of discussion, an investor received 7% in interest for the year; their net loss would have been approximately 2%. Today, with interest rates starting from such a low level, a 2% jump in interest rates on a portfolio with a duration of 4.5 years would result in more significant losses because investors will not have the higher interest rate income to offset the same loss in principal.
If you are still with me, here is what I want you to take away:
1) You must be very aware of the duration of any bond portfolios you own.
2) This time it is different because interest rates are coming off historically low bottoms.
3) I believe there is more risk in bond portfolios than most people realize today.
4) There are more options to invest in bonds than ever before and a smart bond sector strategy can help mitigate the risks of a rising interest rate environment.
LOOKING AHEAD
Markets continue to reach higher and higher levels. As this happens more articles are appearing in the media about bubbles and corrections. There have only been two down months so far this year (June and August for the DJIA and S&P 500) and these pullbacks were relatively modest. The analysis provided by DorseyWright & Associates continues to favor stocks over bonds, currencies, money market, and commodities. Therefore, I am continuing to recommend that investors stay focused on stocks (US and International) for now.
One possible trend I am watching closely has been the recent underperformance of small capitalization stocks compared to the large caps. This trend has been in place only since October and even then in just sporadic patches. Small capitalization stocks represent the riskier aspect of the market and when investors start to lose faith in stocks, there can be a rotation from small cap over to large cap stocks before the markets begin to fade. There is not enough data to support this as a real trend yet, however, I am watching to see how this develops.
I would like to close my Update and Commentary by reminding everyone that this Tuesday, November 19th, marks the 150 anniversary of Abraham Lincoln’s Gettysburg Address. I personally believe that the Gettysburg Address is the finest speech ever given by an American president at what was one of the most critical junctures of our great past. If you have not read Mr. Lincoln’s “humble” remarks recently, I strongly encourage you to do so. His words are as vibrant and strong today as they were 150 years ago, and they capture what is so great about the American character—strength, sacrifice, righteousness, and a true belief in the greatness of our Country. Paul L. Merritt, MBA, C(k)P®, AIF®, CRPC®
Principal
NTrust Wealth Management
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Past performance is not indicative of future results and there is no assurance that any forecasts mentioned in this report will be obtained. Technical analysis is just one form of analysis. You may also want to consider quantitative and fundamental analysis before making any investment decisions.
Information in this update has been obtained from and is based upon sources that NTrust Wealth Management (NTWM) believes to be reliable; however, NTWM does not guarantee its accuracy. All opinions and estimates constitute NTWM's judgment as of the date the update was created and are subject to change without notice. This update is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of a security. Any decision to purchase securities must take into account existing public information on such security or any registered prospectus.
Emerging market investments involve higher risks than investments from developed countries and involve increased risks due to differences in accounting methods, foreign taxation, political instability, and currency fluctuation. The main risks of international investing are currency fluctuations, differences in accounting methods, foreign taxation, economic, political, or financial instability, and lack of timely or reliable information or unfavorable political or legal developments.The commodities industries can be significantly affected by commodity prices, world events, import controls, worldwide competition, government regulations, and economic conditions. Past performance is no guarantee of future results. These investments may not be suitable for all investors, and there is no guarantee that any investment will be able to sell for a profit in the future. The Dow Jones UBS Commodities Index is composed of futures contracts on physical commodities. This index aims to provide a broadly diversified representation of commodity markets as an asset class. The index represents 19 commodities, which are weighted to account for economic significance and market liquidity. This index cannot be traded directly. The CBOE Volatility Index - more commonly referred to as "VIX" - is an up-to-the-minute market estimate of expected volatility that is calculated by using real-time S&P 500® Index (SPX) option bid/ask quotes. VIX uses nearby and second nearby options with at least 8 days left to expiration and then weights them to yield a constant, 30-day measure of the expected volatility of the S&P 500 Index.
TIPS are U.S. government securities designed to protect investors and the future value of their fixed-income investments from the adverse effects of inflation. Using the Consumer Price Index (CPI) as a guide, the value of the bond's principal is adjusted upward to keep pace with inflation. Increase in real interest rates can cause the price of inflation-protected debt securities to decrease. Interest payments on inflation-protected debt securities can be unpredictable.
The NYCE US Dollar Index is a measure that calculates the value of the US dollar through a basket of six currencies, the Euro, the Japanese Yen, the British Pound, the Canadian Dollar, the Swedish Krona, and the Swiss franc. The Euro is the predominant currency making up about 57% of the basket.
Currencies and futures generally are volatile and are not suitable for all investors. Investment in foreign exchange related products is subject to many factors that contribute to or increase volatility, such as national debt levels and trade deficits, changes in domestic and foreign interest rates, and investors’ expectations concerning interest rates, currency exchange rates and global or regional political, economic or financial events and situations.
Corporate bonds contain elements of both interest rate risk and credit risk. Treasury bills are guaranteed by the U.S. government as to the timely payment of principal and interest, and if held to maturity, offer a fixed rate of return and fixed principal value. U.S. Treasury bills do not eliminate market risk. The purchase of bonds is subject to availability and market conditions. There is an inverse relationship between the price of bonds and the yield: when price goes up, yield goes down, and vice versa. Market risk is a consideration if sold or redeemed prior to maturity. Some bonds have call features that may affect income.
The bullish percent indicator (BPI) is a market breath indicator. The indicator is calculated by taking the total number of issues in an index or industry that are generating point and figure buy signals and dividing it by the total number of stocks in that group. The basic rule for using the bullish percent index is that when the BPI is above 70%, the market is overbought, and conversely when the indicator is below 30%, the market is oversold. The most popular BPI is the NYSE Bullish Percent Index, which is the tool of choice for famed point and figure analyst, Thomas Dorsey.
All indices are unmanaged and are not available for direct investment by the public. Past performance is not indicative of future results. The S&P 500 is based on the average performance of the 500 industrial stocks monitored by Standard & Poors and is a capitalization-weighted index meaning the larger companies have a larger weighting of the index. The S&P 500 Equal Weighted Index is determined by giving each company in the index an equal weighting to each of the 500 companies that comprise the index. The Dow Jones Industrial Average is based on the average performance of 30 large U.S. companies monitored by Dow Jones & Company. The Russell 2000 Index Is comprised of the 2000 smallest companies of the Russell 3000 Index, which is comprised of the 3000 biggest companies in the US. The NASDAQ Composite Index (NASDAQ) is an index representing the securities traded on the NASDAQ stock market and is comprised of over 3000 issues. It has a heavy bias towards technology and growth stocks. The STOXX® Europe 600 is derived from the STOXX Europe Total Market Index (TMI) and is a subset of the STOXX Global 1800 Index. With a fixed number of 600 components, the STOXX Europe 600 represents large, mid, and small capitalization countries of the European region. The Dow Jones Global ex-US index represents 77 countries and covers more than 98% of the world's market capitalization. A full complement of subindices, measuring both sectors and stock-size segments, are calculated for each country and region.
