July 30, 2013 - Here's what happened in the stock/bond markets last week

Stock Market Analysis

Conclusions: This was the week the market forgot. The Dow barely rose, 0.1%, the S&P 500 fell 0.03% while the small cap Russell 2000 fell all of 0.2%. It may be because of vacations, the Royal birth or talk about replacing Fed Chairman Bernanke. Nonetheless, a few more stocks fell than rose in price while 552 stocks hit new 52 week highs. Healthcare and Technology had a good week while Oil stocks slipped. Even Facebook had a good earnings report and it rose more than 25% in one day.

Of course, the lack of movement may reflect the conundrum investors now face. Where should they be investing? Money markets are paying little to nothing, gold took a major spill, bonds have been volatile and emerging markets have lost ground. It would seem that stocks are the only game in town, but seemingly, everyone knows this, which makes it less appealing. In addition, stocks aren’t cheap – the S&P 500 has a PE of almost 20, is trading over three times book value and only pays a dividend yield of 2.1%. Thus, we have a “Conundrum Crisis.”

As a former fighter pilot, when faced with a crisis while flying, I was taught to go back to the basics. First and foremost, keep flying the plane, then assess the situation and take appropriate action. For forty years we have lived and worked with numerous conundrums and we developed The Seven Timeless Principles of Investing (the book I wrote) to deal with these.

First, we need to know ourselves. We need to revisit our temperament, our goals and our discipline. This forms the philosophy behind our investments. At JIR it boils down to “What is the least risk we can take that doesn’t prevent gains?”

Second, we need to avoid losing money. One way to measure this is the volatility of an investment and the likelihood it may lose money. Ibbottson reports that stocks are about 3 times as volatile as intermediate term bonds. Furthermore, they have lost money 24 times since 1926 while intermediate term bonds only lost money 9 times and the worst loss was only 5.1%. Having a blend of stocks, bonds and cash is a good way to prevent losing money.

The last principle is to Diversify, Diversify, Diversify. This means across asset classes, sectors of the stock and bond market as well as among individual stocks and bonds. This helps lower the volatility and increases our ability to stay focused on the long term and not the latest trend. This is essential in achieving our goals.

Our discipline and our process use these and other of our Seven Timeless Principles. We’ve seen manias come and go, rising and falling stock and bond markets, disasters like 9/11 and the financial crisis of 2008. Keeping a level head and staying with our discipline has worked well. We don’t know everything and we aren’t right all the time, but we have confidence in our approach and our risk indicators. They are giving no clear direction at this time, which means to keep the last one in mind. The last clear reading was for higher risk and prices are extended. While they may get more so, we believe it best to maintain a conservative position in equities for now.

Barry R. James, CFA, CIC

Bond Market Analysis

Conclusion: Bonds remain in their recent trading range, although yields rose this last week. The ten year treasury now yields 2.58% while the 30 year treasury yields 3.61%. For the year, every major sector of the bond market has lost ground except for high yield bonds. The worst performing sectors have been been long term treasury and municipal bonds. The rise in treasury yields and poor performance is understandable in part due to the uncertainty about Federal Reserve actions.

The situation with municipal bonds is more than merely a reflection of rising rates. Investors seem a bit leery about municipal bonds. This is somewhat surprising given the tax hikes earlier this year. However, rumblings of municipal bankruptcies, a la Detroit, have rightly given investors the jitters. Barron’s reports that 83% of Moody’s ratings actions were downgrades in the second quarter. This includes a drop of three ratings for Chicago. However, it should be noted that Moody’s only rates 34 out of 7500 municipalities below investment grade. Municipal bonds still pay excellent yields relative to treasury bonds and the move may be overdone.

Inflation remains mute and the economy isn’t giving too many signs of over accelerating. Even though some consumer confidence surveys are rising, we might be concerned if actual consumer spending were heating up. We have been seeing lethargic retail sales in many key sectors and corporate revenue (sales) estimates have been slipping. In the last twelve weeks, sales estimates for S&P 500 stocks have fallen about 0.9%.

Over the last month we have suggested taking action to limit the volatility of bond portfolios. However, investors are wise to keep some money in bonds to offset the risks in stocks. As mentioned in our stock analysis, intermediate term bonds are much less volatile than stocks and going back to 1926, their worst yearly loss was only 5.1%. Our research shows owning some bonds helps investors reduce volatility without reducing returns very much. The short term trend is not favorable for bonds, but our risk indicators give us some confidence this shouldn’t last. We would continue to hold high quality bonds of modest duration.

Barry R James, CFA, CIC