Investment Review and Outlook

Fall 2013

The quarter ended with a surprising turn as the Federal Reserve’s much-anticipated shift toward tapering its monthly bond buying failed to materialize. Shortly thereafter, monetary policy was upstaged by fiscal policy as Congress clashed over the budget and allowed a government shutdown (which began just after the quarter ended).

Despite these twists and turns, stocks posted another strong quarter (see chart). Large-caps rose 5% and are now up 20% for the year to date. International markets improved in the third quarter following a rocky start to the year.

Emerging market stocks as a group rose for the quarter (despite losses for some countries) and developed international markets outperformed U.S. stocks by a wide margin. China showed signs of stronger growth.

Core bonds were modestly positive for the quarter, thanks in large part to a rebound in September. The Fed’s decision to stand pat, combined with investor risk-aversion in the face of an impending budget stalemate (and looming debt-ceiling standoff) were favorable for bonds.

We are in a time of investment uncertainty, where an unusually broad range of outcomes remain possible.

 

Investment Review and Outlook

Despite the Federal Reserve’s changing monetary policy decisions and the fiscal policy clashes in Congress, stocks posted another strong quarter. Large-cap, international and emerging market stocks were all up for the quarter. These gains have occurred even as the U.S. economic recovery remains only moderate and corporate earnings growth has slowed.

Both inflation and deflation risks exist, and both are bad for risk assets, including stocks and real estate. Our economy is still fighting significant deflationary headwinds due to ongoing private- and public-sector deleveraging. At the same time, the experimental monetary policy of keeping short-term interest rates near zero over extended periods could easily stoke inflation, we just don’t know when.

Benchmark Funds	Q3 2013	12 Months Ending 9/30/2013
U.S. Large Cap Vanguard 500 Index Fund	+5.2%	+19.2%
U.S. Large Cap Value iShares Russell 1000 Value Index	+3.9%	+22.0%
U.S. Small Cap iShares Russell 2000 Index	+10.2%	+30.1%
U.S. Small Cap Value iShares Russell 2000 Value Index	+7.6%	+24.8%
International Vanguard Total International Stock Index Fund	-10.3%	+17.1%
Emerging Markets Vanguard MSCI Emerging Markets ETF	-4.8%	-0.1%
U.S. REITs Vanguard REIT ETF	-3.0%	+5.7%
Investment-Grade Bonds iShares Core Total U.S. Bond Market ETF	*0.6%	-1.8%

 

Bond-Oriented Portfolios

To protect our bond-oriented portfolios from a recession or deflation outcome, we continue to have a decent allocation to investment-grade or core bonds. In such an environment, interest rates would likely fall, and core bonds would increase in value as most risky assets are declining. Given their very low yield levels, core bonds would still do a much better job of protecting capital than most other asset classes in this scenario. However, relative to history, core bonds carry a significant opportunity cost. Despite a recent spike, interest rates remain very low by historical standards, which mean that expected returns from core bonds are extremely low.

Roughly half of our bond allocation is to flexible bond funds. In a recession/deflation scenario, these bond funds are likely to lag core bond funds that have a longer duration and heavier emphasis on Treasury bonds. The ability of these bond funds to add value is by investing opportunistically across fixed-income sectors without being constrained by the core benchmark, as well as from individual issue selection.

Why Bother Investing Outside the United States?

We have investments outside the United States as part of our very long-term or “strategic” allocation. The graphic, “Frequency of Which Non-U.S. Stocks Outpaced U.S. Stocks” shows the top performers in various calendar year (CY) periods. Over the past 25 years, non-U.S. stocks outperformed in 15 of those 25 years, while U.S. stocks were the winner in 10 of those years.

The most important reason for having a globally diversified strategic mix is that it should provide a much smoother ride than just being invested in U.S. stocks. The case for having a dedicated long-term allocation to emerging markets is particularly compelling.

Taking Stock of Emerging Markets

On a purchasing-power-parity basis, emerging-markets’ share of world GDP has grown from 37% in the late 1990s to nearly 50% as of 2012. Yet emerging markets still represent a much smaller share of global market value (on a market cap basis). The rapid pace of knowledge transfer from developing nations ultimately contributes to higher productivity, per-capita incomes, GDP, and profit growth in emerging economies. As this plays out, emerging-market countries will see the gap narrow between their share of world GDP and market cap. We want our clients to participate in this long-term opportunity.

Emerging-markets stocks were hit especially hard this year after the Fed indicated its intent to taper quantitative easing. Over the last couple of years, emerging markets have underperformed U.S. stocks. We believe the problems we’ve seen this year in emerging markets are only a blip on what we expect to be a very long-term, upward path. See the Commentary section for more information about why emerging markets is an important asset class.

Professional Portfolio Management

Managing your investment portfolio to withstand various economic scenarios is as much art as science. The key is to strike a reasonable portfolio balance that allows you to meet your risk and return objectives over your lifetime. Long-term investing takes willpower, patience, and the ability to ignore shouts from the talking heads on cable. Any cash needed in the short term (less than five years) should not be invested in the stock market.

Independent financial planners have a different skill set than representatives from brokerage firms who buy and sell stocks and bonds but do not have a duty to act in their clients’ best interest. The SEC defines the suitability standard for an advisor as “a reasonable basis for believing that the recommendation is suitable for you.” But a suitable recommendation is not necessarily the best. Contrast this with the fiduciary standard of care demanded of registered investment advisors (RIAs): “The advisor must place the client’s best interest above his own.” At the end of the day, the brokers have to be loyal to their employers; independent RIAs are more likely to have your best interest at heart.

In Conclusion

Investing should only be done as a part of a comprehensive financial plan. Strategizing your goals is the first step. Next, assess your resources and risk tolerance and determine through quantitative analysis if your assets will support your goals, values, and interests. Taking a long-term view is the best way to have confidence in your future.