Second Quarter 2013 Letter to Clients

“If the market is up, why is my diversified portfolio down?”

That question is on the minds of many investors these days, especially those who have significant allocations to international stocks, real estate stocks and bonds.

Indeed, in Second Quarter 2013, U.S. stocks were virtually the only asset class that posted gains. Most other asset classes – including bonds – saw declines. And since the media focuses its daily stock reports on the Dow Jones Industrial Average, which gained about three percent for the quarter, many investors were surprised to see slight declines in their portfolios in their June statements.

While it is not unusual for asset class performance to bounce around from quarter to quarter and year to year, it is unusual when bonds decline and stocks advance. Typically we think of bonds as the volatility reducer in the portfolio, so when bonds contribute to downside volatility it can be unsettling.

With that in mind, here are several points to keep in mind about the short-term environment in both the stock and bond markets:

1. Bonds are not immune to downturns: While bonds don’t often post negative numbers, it does happen. How conservative or aggressive you are in the bond market determines how often it happens.

For example, the Lehman Aggregate Bond Index of intermediate-term, investment grade bonds last experienced a calendar-year downturn in 1994. In a rising interest-rate environment coming out of the early 1990s recession, the bond market that year experienced a selloff that lasted the better part of the year. Even still, the Lehman Agg’s return of -2.92% was hardly a dramatic plunge in absolute terms.

In contrast, the Merrill Lynch High Yield Bond Index, which tracks the performance of junk (below investment grade) bonds, has posted declines in four of the past twenty years – including a whopping 26.21% decline in 2008.

At Capital Directions, we invest strictly in investment grade, short-to-intermediate term bonds. Such investments do occasionally decline in value – as they did this quarter – but these declines are usually infrequent and minimal. Many bond investors, however, have migrated to the longer term, lower credit quality end of the bond spectrum in an effort to boost returns in a low interest rate environment. Those investors may be in for a rude awakening when interest rates begin moving up and their portfolios experience equity-like volatility in their bond portfolios.

2. Bond investors have safeguards in a rising interest rate environment: Investors in bond funds can be assured that their funds will be purchasing new bonds with higher interest rates, effectively raising the yield on their funds. Investors in individual bonds may see a price decline on the bonds in their portfolios in a rising interest rate environment, but those bonds can be held to maturity. This allows the individual bond investor to redeem all of their principal and reinvest the proceeds in bonds paying higher interest rates.

3. Asset class performance in the short-term is wildly unpredictable: It is hard to overemphasize how meaningless short-term performance is for long-term investors. In any given year – much less any given quarter – asset-class performance will vary greatly. Consider the following chart, which we affectionately refer to as “The Quilt”:
Clearly, asset-class performance is chaotic in the short-term. To be successful in the long term, investors must tune out the noise and stay committed to their investment plan.

4. There is both a cost and a benefit to diversification: In periods of time in which U.S. stocks lead the market – such as this past quarter and for all of 2011 – it may seem as if diversification adds no value. Why, we wonder, should we invest in these other asset classes if all they are doing is “dragging on returns?”

The answer is that diversification is a long-term risk reduction strategy that greatly reduces the risk of bad guessing. Investors who choose to concentrate their portfolios in one segment of the market – whether that is U.S. stocks, international stocks, bonds, or whatever the case may be – are essentially making a guess that this asset class will outperform all others going forward. These investors run a huge risk that they end up being in the wrong sector at the wrong time.

Investors in large, U.S. stocks such as the S&P 500 experienced this painful reality during the entire decade of the 2000s. In that eleven-year run, large U.S. stocks declined 9.10%, while other asset classes enjoyed huge gains, as seen in the following chart:

The tradeoff for greatly reducing the considerable risks that come with a concentrated portfolio is that a diversified portfolio will not outpace the Dow or S&P 500 during periods of time when large, U.S. stocks are leading the market. We believe this tradeoff is well worth it when considering the downside risks of a concentrated portfolio.

5. The U.S. only accounts for less than half the world’s stock market: For the better part of the twentieth century, the U.S. stock market accounted for more than 70 percent of world market capitalization. Even in the mid-1980s, the U.S. was still more than half of the world market. Today, however, U.S. stocks account for only about 46% of world market capitalization. In contrast, the emerging markets sector – once only a tiny slice of the global market – now accounts for about 15 percent.

While we are enthusiastic believers in U.S. companies, we also believe it is important to capture the returns that are being offered around the world in the other 54% of the global stock market. We accomplish this through allocations to international large and small stocks, emerging markets stocks, and international REIT stocks. There will be times when these sectors trail the domestic markets, but we strongly believe our clients will benefit from these allocations over the long run.

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The news media is obsessed with what seems to be the impending end of “Quantitative Easing,” the Federal Reserve’s program of keeping short-term interest rates low by buying billions of dollars of government bonds every month.

Whether that program is wound down in 2013, 2014 or beyond, it will certainly come to an end at some point, and interest rates will no doubt rise when that happens. While there is much handwringing in the media about the potentially negative impacts of this on the stock market, it should be noted that the end to Quantitative Easing will only occur when the economy is growing at a pace the Fed is comfortable with. So while there may be some volatility in the short-term associated with rising rates, over the long term the prospects of a stronger economy bode very well for the stock market.