The first stock market downturn arrived in June after seven consecutive months of positive returns. The U.S. markets declined only a little more than 1% and foreign markets (the EAFE Index) declined about 3.5%. After yearly gains of over 20%, it is surprising how rattled some investors get after a tiny bit of profit taking. A small amount of profit taking is normal. It’s expected. Relax.
The bigger story in June was the bond market. The 10-year U.S. Treasury Note continued its trend toward higher interest rates and lower prices. The yield, which was 1.67% at the end of April, increased from 2.13% to 2.49% last month. This is a rather large move in a 2-month period and it had investors panicking that now we are going to see the interest rate spike and bond market crash they have been expecting.
We disagree. We think 1.67% was unrealistically low and the bounce back to 2.5% is nothing to get overly excited about.
Conventional wisdom among the “doomsday investors” is that the Fed has “printed” a lot of money, which is going to result in a devaluation of the dollar. Therefore, we will soon experience hyperinflation and runaway interest rates. The investment solution to this problem is to buy gold, ammunition, land and canned goods. I’m not sure how the ammunition and canned goods are working out, but gold is SCREAMING that we are NOT going to experience inflation. After trading as high as $1,900 per ounce in September 2011, gold finished June at $1,200 per ounce, down 37%. And oh, by the way, gold does not pay dividends or interest. Like all doomsday investments, buying gold was a bit premature.
Interest rates went up in June because Federal Reserve Chairman Ben Bernanke stated in a news conference that if the economy and job market continues to improve, the Fed would begin to scale back its $85 billion per month government bond and mortgages purchasing. He stated that a key statistic is the jobless rate. If it declines from 7.6% to 7% or less, this might cause the Fed to taper its buying of bonds and mortgages. This makes perfect sense to us. If the economy is getting better, of course we don’t need additional Fed intervention. (Quite frankly, we don’t think Fed intervention is necessary now, but that’s for another Investment Commentary). We don’t see the Fed’s “tapering” of bond purchases as having a large detrimental effect on the overall bond market. The Fed receives way too much credit for interest rates being low and it will receive way too much blame if interest rates increase.
What will drive interest rates higher will be economic events that are “unexpected.” Expected economic events are already built into the price of bonds and the yield curve. We have been expecting the Fed to announce a decrease in purchases of bonds and mortgages. Everyone should be aware the Fed will eventually end that program. Anyone who is not expecting the Fed to eventually scale back is just not paying attention.
So don’t look for the Fed’s “tapering” of bond purchases to have a significant impact on interest rates. We aren’t.
Several years ago, we increased our allocation to municipal bonds. Specifically zero-coupon municipal bonds mostly from cities in California. It was totally a contrarian move, and in retrospect, it turned out to have been a great decision. Over the past two years, the panic in the municipal bond market subsided and we were able to sell a lot of those bonds with significant gains, thereby reducing our allocation to municipal bonds. At that time, I didn’t think we would be re-visiting the municipal bond market again so soon, but we are starting to see some attractive relative values in municipal bonds (in general, not just California zero-coupon bonds). However, they aren’t quite the screaming values they were three years ago.
The graph below illustrates what I am talking about. It dates back to 1981, the year I was a rookie in the investment industry. This graph illustrates the interest rate on the U.S. 30-year Treasury Bond (the yellow line) and the interest rate on the 20-year General Obligation Municipal Bond rated AA, considered the safest of municipal bonds (the white line).
For most of the 32-year stretch, high-quality municipal bonds traded with an interest rate lower than the 30-year Treasury bond. During the economic meltdown of 2008, virtually ALL bonds considered “non-Treasury” traded with an interest rate much higher than Treasury Bonds. A little over two years later, municipal bonds experienced another scare when a famous Wall Street “expert” predicted massive defaults in municipalities all across the country (but especially in California). The higher interest rates in municipal bonds were the result of massive panic in virtually all types of non-governmental bonds. Remember, when bond prices decline; interest rates increase. So when you see the increased interest rate on the municipal bonds in 2008 and 2010, that means prices of municipal bonds became a lot cheaper. Both events were spectacular buying opportunities.
Carrying that logic a little further, you can see at the very end of the graph (2013) that the interest rate on municipal bonds has again exceeded the 30-year Treasury rate by a significant margin. Once again, we feel there are some exceptional values in municipal bonds.
The economy continues to plod along in a positive fashion:
- U.S. personal income increased in May
- Home prices are up this year versus last year
- New home sales are at a 5-year high
- Consumer confidence is the highest it has been since 2008
I’ve included the graph below in my Investment Commentary from time to time. It illustrates the economic crisis as well as any graph I have seen. This graph shows the number of new monthly foreclosure filings in the United States dating back to the end of 2004. I will probably never include this graph again. This ugly chapter in our country’s history is clearly almost completely over and I am sure we will not repeat this mistake again in my lifetime…or at least my career.
You can see that the number of monthly new foreclosure filings has declined from around 350,000 in 2009/2010 (an annual rate of 4,200,000 people being forced to leave their homes) to around 150,000 today. Needless to say (but I will anyway), housing prices bottomed several months ago and sales of new homes, as well as existing homes, have increased across the country.
At Boyer & Corporon Wealth Management, we slightly reduced our equity allocation last month simply because the stock markets had increased seven months in a row. It’s always best to take some profits off the table at precisely the time you least want to. As noted earlier in this Investment Commentary, we are seeing good relative value in municipal bonds and have (again) increased our allocation to that asset class. At this time we are not concerned about a pending bond market crash or a spike in interest rates.
This information is provided for general information purposes only and should not be construed as investment, tax, or legal advice. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.