My F&M

Market Commentary 1st Quarter 2013

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The first quarter began as the "fiscal cliff" was averted by a deal reversing the temporary cut in Social Security taxes and increasing some income tax rates.  It ended with a mishandled banking crisis in Cyprus, punctuated by shrill North Korean saber rattling.  In between, we sailed past the Sequester, reducing the rate of growth in federal spending.  Oh yes, and stocks rose to a new high as nothing seemed able to reverse the market’s upward progress!  In the first quarter, the S&P 500 produced a total return of 10.6%, one of its better first quarter performances ever.  Small stocks did a little better, international stocks did worse, and bonds were about flat.  At the same time, home prices moved up, the economy kept expanding (slowly), inflation remained tame, and interest rates remained exceptionally low.  All must be right with the world!  Right?!

The problem is that little of that progress appears "real", built as they are on a foundation of low interest rates that are artificially suppressed.  Thanks to the Federal Reserve (and the European Central Bank, the Bank of Japan, etc.), interest rates are unnaturally low.  Ten year Treasuries usually yield about the same as the rate of nominal GDP growth - implying something like a 4% normal yield today.  But they don't yield 4% today, or 3%, or even 2%.  They yield 1.7%.  Short term rates often yield about inflation plus a half of a percent or so.  With inflation currently about 2% a year, one might expect short term interest rates to be about 2.5%.  Instead, money funds yield essentially nothing.

But because money funds yield nothing and high grade bonds only a little more, investors of all stripes have been forced to reach for yield, holding riskier assets than they would otherwise prefer.  "Don't fight the Fed!" goes the adage.  And it works ... until it doesn't.  And therein lies the rub.  Too many holders of risky assets are just "renters", temporary holders who expect the prices of those assets to drop when the Fed cuts back its bond purchases (running now at $1 Trillion per year), and who expect to "get out" when they "see" that happening.  This is not likely to end well.

So what are we doing about it?  In the last several quarters we've incrementally reduced portfolio risks in numerous ways.  Most recently, you know of our purchases of reinsurance bond mutual funds.  Reinsurance bonds have other meaningful risks but have essentially no risk due to stock markets, the economy, inflation, bond prices, or Fed policy.  This makes them wonderful diversifiers.  We initially planned a 2% position in these funds across the board.  Later, we took the opportunity to increase positions to as much as 3% of many accounts with sufficient liquidity.

At this point, we plan to make an additional de-risking step soon involving a few stock swaps, each designed to replace a typically more volatile stock with one having less expected market risk.  Going forward, as long as interest rates remain unnaturally low, we expect to periodically take advantage of any additional market strength to keep reducing portfolio risk. 

Investors are generally happy as portfolio returns have been strong of late.  But the more central bankers maintain extraordinary monetary easing and the more stocks move higher and interest rates lower, the less comfortable we get.  We think this is an unusually challenging time to be an investor.