Quarterly Commentary:
July 2004
Our Approach
Our overriding principle is that our clients understand how we manage their money. It is a collaborative process. Our clients must understand why we believe a particular asset allocation is appropriate for their individual situation, and is consistent with our outlook and anticipation of market conditions. Above all, our clients must be comfortable with our decision-making process. The “best” investment plan is inappropriate if the client is uncomfortable with the level of risk or specific investment choices.
It is your money. The more you understand what we do, the more productive our relationship can be.
We refuse to engage any client who insists on viewing the investment process as a mystery, or expects the investment manager to buy the next hot stock, or proceed with vague instructions to “make lots of money.” Such clients have unrealistic expectations, and will lack conviction in fluctuating markets.
The Quarter in Review
A fundamental psychological shift occurred early in the quarter. The April jobs report was better than anticipated, and the Federal Reserve announced it would increase the federal funds rate at a measured pace, in response to rising inflation and an improving economy. Markets were volatile, but ultimately little changed, as investors repositioned for a trending increase in interest rates.
Equities in the Second Quarter
Style Breakdown:
|
- 0.57% |
|
+ 1.02% |
|
+ 0.43% |
|
+ 1.07% |
|
- 1.3% |
|
– 2.66% |
|
- 20.76% |
An interesting note is the recent winners and losers. Gold, silver, small cap and technology stocks were the biggest gainers last year, but declined dramatically this year. It is certainly a cautionary example of attempting to chase last year’s winners.
Fixed-Income in Second Quarter
We were clobbered. Bonds followed a record first quarter with the worst second quarter performance since 1980.
* iShares Lehman 1-3 year Bond Fund -1.75%
* iShares Lehman 7-10 year Bond Fund: -6%
* iShares Lehman Aggregate Bond Fund -2.2%
These percentages refer to capital gains and losses only. Fixed-income instruments also pay a coupon, which is reinvested to calculate total return. Our fixed-income strategy is outlined in this report.
Market Risks
The Economy
The risks are substantial. Three years of artificially-low interest rates have created an over-valuation (arguably a bubble) in every asset class: stocks, bonds, and real estate. Prices have been further exaggerated through leverage, as lax lending standards and variable rates have exploded the debt burden of households, businesses, and governmental entities. Rising interest rates against such debt burdens, coupled with the mounting federal deficit and record energy costs, threaten the recovery and the recent progress of the stock market.
There were signs of recovery in the second quarter. If the recovery is organic (genuine, sustained), in theory, debt burden and asset prices should become proportionally more rational and sustainable. If we are experiencing a liquidity recovery (an economic “spark” as a result of such massive infusion of cheap money and leverage), then the economy will lapse back into a recession once interest rates rise.
Bonds and fixed-income securities will directly decline in value as interest rates trend upward. As such, an economic recovery and very low interest rates argue for a greater allocation weighting in equities, at least initially. However, rising interest rates must be offset by inflation and sustained economic growth for equities to continue to perform.
Terrorism
Another significant act of terrorism, particularly on American soil, can very well result in another economic flee to safety; i.e. transfer of funds from equities to Treasuries and other fixed-income securities. As such, we remain diversified in fixed-income securities, if only as a hedge against such risk.
Strategy for Third Quarter
Overall, we agree with Morningstar and expect a holding pattern for the stock market and volatility in the bond market, probably until the November election. Unanticipated action by the Federal Reserve or the terrorists can easily disturb this scenario. We believe the markets have the potential for severe volatility.
Asset Allocation
For the second quarter, we advocated a weighting of about 40% in fixed income and about 60% in equities. This was a suitable risk/reward weighting for most of our clients. Based upon anticipated market conditions, we will give greater weight to equities, i.e., about 70%, and reduce fixed-income exposure to about 30% in the third quarter.
Equities
We rarely buy individual stocks. It is time-consuming and an inefficient method of diversification, particularly for the smaller portfolio.
Mutual funds are great tools for diversification. However, they are expensive. Management and transaction fees within a fund can easily exceed 2% per year.
On Wall Street, mutual funds are classified as “packaged products.” They are created and marketed specifically to appeal to the consuming public. We have plotted the most popular funds against the applicable index fund to compare performance. Over time, most fail to match the index. It is easier and cheaper to buy the index and avoid the fees.
We will continue to use high-quality, balanced funds for our smaller accounts. Our current favorite is Dodge & Cox Balanced fund.
Exchange-traded funds have matured over the last few years. These index funds achieve the same goals as mutual funds, but at a fraction of the cost. Much of the investment community is transitioning to these funds to create more cost-effective portfolios.
An advantage of exchange-traded funds is the ability to use a stop-loss order. This feature will be important in our trading tactics.
Fixed-Income
Fixed-income securities are much harder to conceptualize than equities, because there are more moving parts. A stock price moves up or down. Bonds have different maturity dates, different yields, changing yield curves, and coupon reinvestment. All these variables must be considered, as all contribute to the total return.
In a rising interest rate market, particularly from such a low base, there are no completely satisfactory fixed-income strategies. Every approach requires some trade-off of yield or safety of principal, and some basic assumptions about future interest rates.
Yield versus Safety of Principal
The most prevalent strategy in a rising market is to invest in securities with a very short maturity. This minimizes capital loss as rates rise and all bond-like instruments lose value. However, bonds with a very short maturity pay a very low interest rate. Short-term rates are currently so negligible that such a strategy is akin to shoving the money under your mattress. This may be tolerable in the short run, but such market conditions may persist (and have persisted) for years. As money managers, or anyone wishing to maintain pace with inflation and purchasing power, this is unacceptable for the long run.
A second strategy is to purchase bond-like instruments, such as preferred stock funds or REITS, which pay a (somewhat) higher “coupon” than bonds, but with (somewhat) less risk to principal in a rising market. These coupons are reinvested at higher future rates. Over time, the total return of this strategy should be superior in most market scenarios.
Tactics for Third Quarter
For most accounts, we transitioned from mutual funds to exchange-traded funds at the end of the first quarter. Our practice is to limit reallocation to about once a quarter. We permit ourselves to trade occasionally if an opportunity presents itself. But experience teaches that, over time, it is generally better to sit tight. Active trading often leads to over-reaction to market and current events, and we start to make mistakes.
Based on our expectation of a drifting market, with potential for volatility, we intend to implement a few practice changes to complement our basic approach.
- Preference for Yield-Bearing Instruments. All else being equal, we prefer securities that pay a coupon or dividend, as well as offer capital gains.
- A Little More Trading. We are not comfortable with a passive buy-and-hold approach in this market. We will act upon trading opportunities as presented, through structured, pre-determined buy and sell parameters.
- Cash Build-Up. We cannot buy low if we are always fully invested. At times we will realize gains, and wait, in cash or other money-market instrument, for a buying opportunity. If cash builds up in your account, it is deliberate.
- Aggressive Stop-Loss Orders. We will implement stop-loss orders to lock-in gains and minimize catastrophic loss. Stop-loss points and tactics are not fool-proof. But there may be more trading activity in your account as a result.
Equities
Our equity weighing for the second quarter was as follows:
| Diamonds (DVY) – dividend-paying Dow Stocks | 15% (total portfolio) |
| Spiders (SPY) – S&P index | 20% |
| iShares Europe (EZU) | 7.5% |
| iShares Japan (EWJ) | 7.5% |
| iShares Russell 2000 (IWM)– small blend | 6% |
| iShares Technology (QQQ) | 6% |
| iShares International (EFA) | 5% |
Our equity holdings were weighed toward larger-capitalized stocks and international stocks, which were appropriate, given the resultant performance. Overall, we are comfortable maintaining this basic allocation for the third quarter.
There has been much talk about inflation, and the opportunities in commodities and oil stocks. We have watched these indices over time, and have not discerned a logical approach to invest and profit in these areas. There is too much of a casino feel to these sectors, and we will avoid them until we feel we understand what we are doing.
Fixed-Income
We believe the rout in fixed-income is about over, at least for now. We also believe the Federal Reserve is ultimately limited in its ability to act, as a precipitous rise in interest rates will tip over our debt-laden economy. As such, we stand by our current strategy.
Fixed-income securities declined so much in the second quarter, from both emotional selling and de-leveraging by professional investors, that bonds became very cheap for a time. Most of our purchases this spring were closed-end bond funds.
- iShares Lehman 1-3 year Treasury bond fund (SHY). A classic short-term bond fund; yields about 1.5%, yet still declined about 1.75%. Sterile money, but to a certain extent necessary for diversification.
- Nuveen Preferred closed-end fund (JPS). A closed-end fund trades like a stock on the exchange; much different than an open-end fund. This preferred stock fund is leveraged by about 30% to enhance the yield. Leveraging works as long as there is a positive slope to the yield curve (short rates are low, long rates are high). Yield ranges from 7.5% – 9%, depending on purchase price.
Admittedly, this is a gutsier strategy in a rising market, and was a little more volatile than we expected over the last few months. Many closed-end funds were created during the bull market, and the market is still deciding how to price them in a rising environment. But the net asset value is there and those high coupon payments will be reinvested. We believe this investment will prove itself.
- Nuveen Senior Lien Notes (NSL). A closed-end bond fund, invests in corporate senior lien loans, leveraged by about 30% to enhance yield. Loan rates adjust annually, so price fluctuation should be minimal. Currently yields about 5.1%.
- Kensington REIT. Yields about 6.5%, depending on purchase price. Should be less price sensitive than traditional fixed-income investments. Also hedge against inflation, as rental income increases with economic recovery.
- Van Kampen Strategic Sector Municipal Trust (VKS). Closed-end municipal bond fund for our individual clients in taxable accounts. Yields about 7.5% tax-exempt interest, 11.6% taxable equivalent.