September 2013 Market Commentary
With the 3rd quarter almost over storm clouds seem to be gathering and making money the rest of the year is looking increasingly tenuous. With the recent announcement by Fed Chairman Bernanke that the long awaited tapering of bond purchases by the Fed will not happen yet the stock and bond markets have rallied on the news. The S&P 500 Index has reached record territory and the 10 year Treasury yield has dropped to 2.7% as of today from almost 3% just a couple weeks ago. With another chance for political gridlock from the coming debt ceiling debate to slower job creation of recent, the stock market, up over 20% for the year, could be in for tougher times ahead. Interest rates, which have climbed dramatically since mid-May, will most likely continue to rise some from here or remain flat at best making bonds a poor choice as well.
The bond market sell-off in May and the resultant reaction by investors, which reminded us briefly of 2008, have caused us to re-evaluate how we think about some of the investments we own and the asset class we viewed them part of. For example where we used to think of energy master limited partnerships (MLPs) as an inflation sensitive asset, its recent behavior has made us move it to our non-traditional equity bucket. Another example is moving mortgage REITs from non-traditional fixed income to non-traditional equities. We need to be dynamic in our thinking as well as in our approach. Additionally we’re going to reduce the number of sleeves we invest in from six to five by combining the traditional and non-traditional fixed income sleeves into one. This change more accurately reflects our overall fixed income exposure as a result of re-classifying some of our holdings as described above. Lastly we’re going to change the name of our non-traditional equity sleeve to the income equities sleeve as everything we’re investing in here has an income component to it.
Here are some thoughts on the five different asset classes we now invest in:
It’s getting increasingly difficult to find anything really compelling to invest in here at home. With the U.S. markets at record territory we’re turning more cautious. That leads us to believe that others are thinking the same thing. While everyone would like to be bullish about things, unless you can make sense of the environment money flows into risk assets will likely slow and that doesn’t bode well for U.S. stocks. The equity markets are getting stretched and people are talking more about bonds being a bad bet as the reason stocks may be a good bet which is worrisome. Overseas things look more reasonable. In this global recovery the play is developed markets especially Europe and Japan, not emerging markets like India, Turkey and Brazil. If things get worse in the world the U.S. market and markets elsewhere probably pull back the same but if the world continues to recover slowly we think there’s more upside in these overseas developed markets than here at home at this point.
The recent bond market sell-off has affected most income oriented equities as well. As a result there’s a buying opportunity today unless interest rates continue to rise dramatically from here. Things like commercial mortgage REITs and residential mortgage REITs have come under real pressure and appear to offer reasonable value at these levels. Multi-strategy credit mutual funds, typically in closed end form, offer both a high dividend yield and potential growth of principal. These funds are currently selling at discounts to their net asset values and offer dividend yields in some cases over 8%. MLPs have drawn a tremendous amount of interest from the investing public as a result of their relatively high yields and strong distribution growth and are trading at the high end of their valuation range. We continue to like MLPS despite this in the near term.
Interest rates have risen fairly dramatically from the very low levels they were at in Q2. We see further increases on the horizon but the rate of increase should slow. We’re keeping our portfolio duration on the short side as a result. The market is anticipating an announcement by the Fed of a tapering of bond purchases at the next meeting. If it’s not this meeting it’ll be soon. Municipal bonds have experienced a dramatic sell-off as a result of the rise in interest rates but more importantly from the Detroit bankruptcy filing and to a lesser extent negative news on Puerto Rico. Even though we don’t have any real exposure to either of these areas it’s affected every other bond too. As a result muni’s are a good value relative to Treasury bonds here. Other than muni’s on the credit front most things look pretty picked over from a relative value perspective. Bonds on the low end of the ratings spectrum in the U.S. such as low-rated sub-prime residential mortgages, low-rated commercial mortgages, low-rated corporate loans/bonds and low-rated asset backed bonds like credit cards or auto loans, all offer less than compelling returns at this point. We like senior bank loans due to their floating interest rates but this has become a very popular idea which makes us cautious. Distressed debt offers an opportunity still but it’s difficult to invest in this area unless you’re an institution.
With inflation remaining subdued inflation sensitive investments remain relatively unattractive. We have a small exposure to global real estate and energy. Only farmland, both in the U.S. and overseas, is seeing strong investment interest but it’s almost impossible to find a way to invest in this segment for individual investors. We’ll be watching for signs of acceleration in the rate of inflation.
With money market yields currently below the rate of inflation holding cash is losing you money. As a result we’re trying to hold as little as possible. We’re using floating rate notes and ultra-short term bond funds as a parking spot.
What’s an investor to do?
For us it’s time to be defensive and sit back and wait. We don’t want to make excuses why we should be doing something. Our exposure to overseas stocks, which has hurt us some so far this year as domestic stocks have outperformed, should pay-off the rest of the year if we’re right or wrong about the U.S. markets. On the fixed income front we’ve been relatively short in our maturities which has limited our principal risk. We’ll continue to stay short for the foreseeable future. For most of our clients who own municipal bonds, not taxable bonds, the ongoing resolution of the Detroit bankruptcy filing should hopefully allow the muni market to return to fair value. As protectors of principal rather than aggressive growers of capital we get paid to be nervous and thoughtful. Right now we think the thoughtful thing is to be a little nervous.
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