Second Quarter Review

July 18, 2013

In the second quarter, we saw our first negative monthly stock market return since October, though the 1.35% drop was eclipsed by a mostly-up quarter. A simple balanced portfolio of all U.S. stocks and bonds would have been flat in Q2 as bonds slid in a near-perfect mirror to U.S. stocks.

The Vanguard 500 Index fund (VFINX) was up 2.69% while Total Bond (VBMFX) fell 2.45% for the quarter. Our Conservative Portfolio dropped 0.76% while our Aggressive Portfolio gained 1.02%. All in all, a better quarter to be in growth than income investments.

At one point in June, the market was down roughly 6% from its May highs, but things turned around pretty quickly, and U.S. stocks moved back up to new highs. Most other stock markets are still quite weak, continuing a multi-year pattern of underperformance versus U.S. stocks, in contrast to the multi-year outperformance we witnessed in the early to mid 2000s. Broad international indexes are up just over 2% for the year as of the end of June, while emerging market stock indexes were down about 10% - though markets have picked up so far in July.

Our own relatively small foreign stock and cash allocations kept our portfolios more or less in line with a blend of U.S. stock and bonds. Our sharp underperformers (longer-term bonds and foreign markets) were balanced by good gains in financials, Japanese stocks, and healthcare. Still, it was no quarter to brag about. We're trying to beat a simple balanced portfolio of stocks and bonds, or at least deliver similar returns at a reduced risk level.

There's a lot more money in foreign and emerging market funds now than there was during the actual period of great returns earlier in the 2000s. Vanguard’s $60 billion dollar Emerging Markets fund still sports solid double-digit annualized 10-year returns, but has likely lost investors more money than it's made them over the last decade, due to the sharp climb in assets in recent years.

Even after years of solid returns, this fund had less than three billion in assets in 2004. Shortly thereafter, the professional investing community discovered the wonders of adding "alternative" asset classes to a portfolio to diversify risk away from a U.S. stock-heavy portfolio. Last year this fund has over $70 billion in assets – the vast majority from Vanguard ETF share class growth. Much of our own outperformance in our online portfolios from 2002-2005 occurred as a result of being heavy in foreign stocks and bonds. That strong performance abroad actually continued into late 2007.

But there was more going on than the continued outperformance of U.S. stocks versus foreign stocks. Investors fear the end of low interest rates began  on May 1st (May Day…) when the 10-year government bond started a quick climb from a mere  1.63% yield to  2.6% near the end of June.

According to the Federal Reserve chief (who's likely trying to figure out the smoothest exit possible from adventurous monetary support,) now that our economy's on the mend, we don‘t need the Fed to continue creating money by buying bonds much longer.

The opposite case could be made that a Federal Reserve tightening could mean lower inflation and a slower economy, which would mean low interest rates. If anything, rates could rise from an-asleep-at-the-wheel Fed (with the monetary gas pedal down,) creating inflation and negative real returns for all bonds.

Whatever the reason, Vanguard saw their first monthly outflow of money since 1994,  thanks to a mini run on bonds caused by the shock of quickly-rising interest rates.

This jump in rates caused real havoc in the "yield reach" space – all fund categories that investors use to get higher than a 1.63% safe yield. One notable casualty was emerging market bonds, having gone down 15% as a group in a few short weeks before recovering somewhat, reminiscent of the 2008 slide in emerging market bonds. This was notable, because it was slightly worse than longer-term U.S. government bonds, which investors avoid in favor of investments with less interest rate risk (at the expense of more credit risk).

Initially, this rise in yields (and falling bond prices) coincided with rising stocks as a stronger economy  should be good for earnings and stocks. By  late May, both bonds and stocks headed down as interest rates continued to climb, as it occurred to investors that really high rates couldn’t be that good for earnings and housing. When the worst of the rise in rates was over, stocks resumed their upward trajectory. We can handle 2.6%, but not 4%. Not yet anyway.

Bond investors are particularly skittish; they fear the end of low rates, yet can’t be in zero % cash, and aren’t going to take stock market risk. This money can go quickly back to cash if hits continue, possibly leading to panic and a full-on exit from bond funds, which will drive rates  up even more.

This economy can’t handle much higher rates. Home prices simply won’t go up when monthly payments are skyrocketing. We still have high unemployment. More importantly, the real-estate bubble mentality is gone from real estate. Even with irrationally exuberant real estate buyers, banks are playing it safe and care  about cash down and monthly housing payments being affordable to borrowers – only partially because of new regulations.

If you want something to fear, don’t fear inflation or even the economy. Worry about an irrational bond market panic. On second thought, a bond market collapse might create opportunities to buy bonds at yields far surpassing future inflation rates. Given elevating stock prices, it could even provide  an attractive hedge against the panic-induced higher rates actually causing an economic slowdown.