My F&M

Market Commentary 4th Quarter 2013

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As you know, the stock market was very strong in 2013: the S&P 500’s total return was 32.4%, its best year in the last 15! In stark contrast, emerging market stocks and most defensive investments including bonds, defensively hedged alternatives, and gold all produced losses for the year.

Economic growth is accelerating.  Third quarter GDP estimates were recently revised upward to 4.1% from an initial estimate of 2.8%.  Full year GDP for 2013 was likely lower than the 3rd quarter but still good considering that tax increases may have reduced it by 1.5%.  In 2014, the economy is expected to be a little stronger yet, with tame general inflation.  The federal government does have a debt problem, and that problem grows whenever it operates at a deficit. However, due to sequester spending cuts and tax increases on some, the 2013 federal deficit was about half its 2009 peak.

So, the stock market has been very strong, the economy continues to slowly improve, inflation remains tame, and the federal deficit is (for now) shrinking – what’s not to like?  In two words, “quantitative easing”. Last month, the Federal Reserve began its long anticipated (and, initially feared) ‘”taper”, which turns out to simply mean that for some undetermined period the Fed will only be buying $75 bil. of Treasury and mortgage bonds per month, rather than the previous $85 bil. Markets rejoiced at the assurance that the Fed’s market interventions will continue in a massive if slightly smaller way.

Here’s what we need to really know about what the Fed is doing: they are intentionally and significantly distorting prices in two of the largest, and in many ways, most important financial markets in the world – the markets for US Treasury bonds and for mortgage backed securities. A central tenant of economics is the importance of prices. Markets find their “equilibrium” balance between sellers (supply) and buyers (demand) via the pricing mechanism. In capitalism, prices are freely set by markets – the free interaction of buyers and sellers.  And yet, our current reality is that prices for these critically important financial markets have for some time been significantly distorted by large additional “demand” conjured up by the Fed.

Price impacts aren’t limited to Treasuries and mortgage backed securities. All bonds are essentially priced relative to US Treasury bonds, so pricing distortions in Treasury bonds distort (upward) the prices of all bonds.  Moreover, the stated objective of the Fed has been to increase asset prices (including stocks), and they can do this knowing that inflated values in Treasury bonds inflate stock prices too. Prices of all financial markets have been distorted higher by the Fed’s “quantitative easing”, and this distortion continues with only modest reduction.  Distorted prices by definition do not match true values.  We don’t know exactly how much, but we know current prices are overvalued, that is, higher than they deserve to be based on underlying fundamentals.

Most clients are thrilled to have made so much money from investments last year (even if they wish they had held more US stocks and less of everything else). We’re happy for those gains too, but we’re not happy that leaves us with assets with distorted prices, no apparent near term end to the source of the distortion, and no place to “hide” given essentially zero yield from short term securities.  It’s an unfolding scene with a high probability of a bad ending, but with no way to know when that ending will arrive.  Furthermore, there are large “opportunity costs” if overvalued assets are sold too soon.

When prices rise faster than fundamentals, only some of those gains are “earned” and the rest are just “borrowed” from the future, implying lower future returns than would otherwise have been the case – potentially for years to come.  Return expectations should be adjusted.

In the meantime, we’re on vigilant “storm watch” (with, frankly, little reason to expect that we’ll actually see a storm bearing down with enough notice to react). We do plan, however, to continue to make portfolios progressively more defensive.  We’ve been rebalancing to de-risk and we’ve added a couple of interesting opportunities in uncorrelated assets.  Whenever the next storm does hit, we should be better off for having prepared today.