- In the 3rd Quarter, our client’s portfolio’s adding to the year to date gains, despite a few rough days.
- The current budget negotiations and concerns over the potential failure to raise the US debt ceiling pose short term risks, although the long term outlook remains generally positive.
- Portfolios generally have above average cash balances to provide a buffer against potential declines and to fund purchases of bargains if they occur.
3rd Quarter Financial Market Wrap Up
The strategy of overweighting stocks has paid off well so far in 2013 as the SP500 rose approximately 5% during the 3rd quarter. The fixed income markets produced marginal gains as measured by the Barclays Aggregate Bond Index which gained about 0.5%. Bonds declined in value through early September as the yield on the 10 year Treasury bond approached nearly 3% before rallying as political fears began to emerge late in September.
Commodities, as measured by the GSCI Commodity Index (GSG), rose by 5% in the third quarter after a rough first half of 2013. Oil prices rose due to Middle East concerns and an uptick in worldwide economic activity. Gold rose by 6%, but still remains in a long term down trend after peaking in 2011.
3rd Quarter Financial Market Performance
Barclays Aggregate Bond Index (AGG)
US Dollar (UUP)
Why Bonds Have a Role in a Well Structured Portfolio
Many clients hear about bonds, but are often less familiar with how to value bonds and the role bonds serve to the overall portfolio strategy. A bond is basically an I.O.U. to an issuer which may be a government, municipality, or corporation. Usually twice a year, the issuer will pay interest to the bond holder until the bond matures. At maturity, the issuer will pay the bond holder the principal amount of the bond (usually $1000 per bond). Since the interest rate on the bond (coupon rate) does not usually change, bonds will fluctuate in value relative to the market trends of interest rates, but converge towards the principal value as the maturity date approaches (again, usually $1000 per bond). Bonds are appealing because the return can be reasonably estimated at the time of purchase, assuming the bond is held to maturity. It is similar to knowing the final score of a football game at the opening kickoff.
Generally, our fixed income strategy is to structure bond maturities in a sequence such as 3, 5, 7, and 9 years. This strategy is referred to as a “Bond Ladder” and mitigates the risk of rising interest rates since maturing bonds can be reinvested at higher interest rates.
Historically, stocks are the best performing asset class, with average annual returns of 10.6%. In comparison, long term corporate bonds have returned 5.9%, but with much less variability than stocks (as measured by the standard deviation). (Source: A Random Walk Down Wall Street, Burton Malkiell). Looking forward, while bond returns may be lower than historic returns; since the returns for bonds are usually predictable, it makes them a valuable asset in a portfolio.
Historic (nominal) returns 1926 – 2005, source: Ibbotson Associates
Standard Deviation (Risk)
Large Company Stocks
Long Term Corporate Bonds
Bonds are also a good holding to reduce portfolio risk because of the low correlation between stocks and bonds. According to research by Fidelity, over the past 86 years, stocks have experienced 24 down years. In those 24 down years for stocks, bonds rose in 22 years.
Bonds are also useful in a portfolio to fund future scheduled distributions. For clients who routinely withdraw funds to support their living needs, we target annual bond maturities according to the scheduled distribution dates in amounts equal to a client’s cash needs. This strategy reduces the risk of funds not being available when needed. The academic research behind our bond management strategy is referred to as “Asset/Liability Management” and is based on the practices of how insurance companies match their investments with potential claims of policy holders.
- Looking for economic growth of 2% or better in 4th quarter
- Political risks increasing the uncertainty to short term outlook
- Employment economic impact changing due largely to technology, thus traditional labor market reports may not be telling the right story
- Households improving their financial health with “debt diet”
The economy grew by 2.5% during the second quarter up from 1.1% in the first quarter. The areas of particular strength have been residential real estate, automobiles, and durable goods such as airplanes. The spark provided by these sectors lead to growth in related industries, although the common element is that they are all benefitting from low interest rates.
A Different Look at the Employment Situation
The financial media focuses on the employment report which is released on the first Friday of each month. This report highlights the unemployment rate and the number of new jobs created (until the government shutdown.) Analysts debate the number of jobs created as a proxy for the overall health of the economy. With changes in the economy, healthcare laws, demographic trends, and technology innovation, the focus on this labor market report may lead to an inaccurate conclusion about the overall economy, which may actually be stronger than believed.
Many new industry leading companies have very high sales averages per employee, a result of the leverage of technology. Google and Facebook serve as examples of this trend. Robotics is also having an obvious impact on employment numbers by substituting machines for labor. Less obvious is the impact due to improvements in the technology/robotics industry which have improved productivity thereby reducing or even eliminating the need for labor. For example, by using superior technology provided by Fidelity and Advent software, our firm can efficiently manage more clients than we did while working at the trust banks with inferior software. Our micro-economic example demonstrates how the economy can expand with technology rather than with more labor.
Households on “Financial” Diet Showing Improvement
An emerging and positive economic trend is the reduction in household debt since the financial crisis. Debt as a percentage of personal income or household assets, is at a ten year low; a sign that consumers are using their income to payoff old liabilities and are “debt” adverse in taking on new obligations.
Economic Outlook for 4th Quarter & Beyond
Assuming the present government shutdown and pending debt ceiling debate does not materially impact the economy, (which is a big “if”), the economy should grow by 2% or more in the 4th quarter. In simple terms, the private sector’s growth is trending at 3% or more, but the government sector is contracting by about 1%.
ECONOMIC GROWTH RUN RATE
|+3% or more|
Gross Domestic Product (G.D.P.)
|+2% or more|
Political Impact on Financial Markets
By the time you have read this, the political headlines will have changed, hopefully for the better. With the approval rate of Congress at a record low, investors will appreciate any form of positive forward progress. However, with Democrats and Republicans showing no interest in resolving the situation, the best hope for a breakthrough will be around October 17, or when we reach the debt ceiling.
At the core of the present political crisis are two issues; 1) the lack of a budget for the fiscal year beginning October 1st; and 2) the looming debt ceiling expected to be breached by mid-October. The lack of agreement on both issues poses significant risks to the financial market as time goes on. For example, if the government was in technical default on its debt, Treasury bonds held as collateral for loans may be in default as well. The longer there is no agreement, the greater the impact on the economy will become.
Government Finances Improving
The improvement in the economy, moderation of military activities, and sequester this year (so far), have helped significantly reduce the Federal deficit. As the chart below illustrates, government expenditures (left side of the chart below) are actually declining. Also, with the improvement in the economy, government receipts are up (upper right side of the chart), thus the deficit is dramatically shrinking (see chart on the bottom right side below).
Chart courtesy of Fidelity and ISI.
Reduction in Government Expenditures- Cutting some “muscle”, not just “fat”
Although the lack of ability or willingness for Congress to agree upon a budget has led to mandatory spending cuts or “Sequester”, the good side of this issue is that it has resulted in falling outlays. Specifically, government employment has fallen 0.4% from a year ago and construction of public projects is down 3.7% from a year ago. Even though the improvement in the budget deficit appears good, it bears a cost. Since a significant portion of the budget is considered “entitlements” and as such, is off limits to cuts, discretionary expenditures are significantly impacted. Further, many discretionary expenditures have had greater impact on economic conditions than entitlements such as: funding NASA, medical research, or the Everglades Restoration.
On a more concerning issue, a recent Bloomberg television report indicated that the F.B.I. is faced with cut backs in labor and has been forced to limit miles driven due to a cut in its gas budget. The F.B.I. serves a key function in protecting our capitalistic economy from terrorists, organized crime, and foreign governments looking to disrupt our economy. This is just one example of how the lack of proper government financial support poses a significant economic and security risk.
Strategy and Outlook for 4th Quarter 2013 and Beyond
Stocks – Expect Long Term Bull Market to Re-emerge Once Washington Gets Out of the Way
Generally, most established client accounts are close to being fully allocated to stocks and under weighted in fixed income, while exposure to commodities remains very limited. Over the past quarter, overweighting in stocks has been scaled back. This is due to the anticipated seasonal challenges regarding stocks during the historically weak September and October months coupled with the Government budget and debt ceiling negotiations. The short term bias is to return to an over weighted position in stocks when the market opportunity is appropriate. Once the present concern associated with the political issues is resolved, the long term bullish trend in stocks is anticipated to reemerge. Longer term, stocks could again produce average returns similar to historic total returns of about 10% per year.
SP500 Stock Index – trend remains up
Within the overall stock market, the sectors being eyed for investment include growth oriented mid cap stocks and some sectors of foreign markets.
Bonds – Waiting for the Yield Treasuries to break 3% to Buy
Unlike our heavy exposure to stocks this year, most client accounts have been under weighted in fixed income securities. This year, as interest rates have increased, most intermediate and long term fixed income strategies have lost money for the first time in many years. For the most part, we have minimized bond market damage caused by increasing long term interest rates by keeping maturities of shorter term duration and seeking higher yielding issues. This strategy has worked well.
It is anticipated that when the political issues are resolved, fear in the financial markets will subside and yields will begin to rise again toward the 3% yield on 10 year Treasury bond which makes many sectors more appealing with higher yields.
10 year Treasury Bond Yield – waiting for yields to reach 3% to buy
Within the overall bond market, for taxable portfolios, municipal bonds are especially interest due to tax free yields which are exceeding high grade government issues, an abnormality. The Detroit bankruptcy and concerns over Puerto Rico have scared investors from municipal bonds, which has created the opportunity for potential attractive returns over the long term.
For tax deferred (IRAs and Pension Plans) portfolios, “medium grade” corporate bonds such as Ford, Constellation Brands, or Masco offer about 2% higher yield than Treasuries of similar maturity. For the past several years, assuming a moderate degree of credit risk has been a very profitable strategy for bond investing.
Keep in mind with all bond investments, once a bond is purchased, the total return can be reasonably predicted, assuming the bond is held to maturity.
Tidbits on Notable Equity Holdings
Helmerich & Payne (HP $74) – HP is a leading oil and natural gas drilling company and is well positioned to benefit from the growth in domestic energy sources. HP is believed to have the most technologically advanced drilling rigs, resulting in greater efficiency, fewer environmental problems, and fewer safety issues than competitors. HP shares just recently began to lead the stock market as evidenced by hitting a 52 week high.
Gilead Sciences (GILD $63) – GILD is the worldwide leading provider of HIV drugs, but is on the verge of getting FDA approval for its HCV drug, Sofosbuvir. The FDA is anticipated to rule on their application for marketing the potential billion dollar drug in December. In addition to the HCV product potential, Gilead is working on other new drugs which are needed to offset the loss of patent protection of legacy HIV drugs.
Deere (DE $82) – Within Deere, is a wide divide between their financial performance and the opinions of investment analysts. Deere’s business has been very strong for several years, however, analysts see a peak in farmer’s income; thus the demand for new tractors and sales is expected to decline. Additionally, the wet and cooler weather conditions have led to a huge corn crop, but prices have declined. Analysts tend to rely on corn prices as a proxy for the overall health of Deere. As a result of the negative opinions of analysts, Deere is one of the cheapest stocks in client accounts and offers significant appreciation potential.
Verizon Communications (VZ $47) – The long time rumored buyout of Vodafone’s 45% interest in Verizon Wireless is expected to close in early 2014. Recently, Verizon sold a historically large bond offering to fund a portion of the $130 Billion acquisition. Longer term, Verizon will have higher earnings, but will have a heavy load of debt. Verizon’s stock offers a dividend yield over 4% and moderate, but steady growth.
Qualcomm (QCOM $67) – Qualcomm has recently seen renewed investor interest subsequent to a strong earnings report for the June quarter. It has been difficult for Qualcomm to gain respect from investors despite being the leader of semiconductor devices for mobile communications. A good launch for the new Apple phones would go a long way for “old” tech stocks like Qualcomm since Qualcomm chips are used in many iPhone products.
AmerisourceBergen (ABC $63) – AmerisourceBergen is one of the largest distributors of medical supplies and pharmaceutical products to doctor’s office and drug retailers. ABC will be a direct beneficiary of the Affordable Care Act as the expansion of insurance benefits should lead to higher sales. ABC offers growth potential about equal to the overall equity market, but with a less risk.
iRobot (IRBT $35) – iRobot is often recognized for their popular Roomba robotic vacuum, but their origins are in military applications for reconnaissance and bomb disposal missions. iRobot’s management looks for large scale opportunities, such as consumer markets, but healthcare applications may provide the greatest long term opportunity. Robotics is one of the fastest growing markets; lowering the cost of delivery of products thereby increasing competitiveness with foreign manufactured products.
Copa Airlines (CPA $148) – Copa is Panama based airline servicing Latin America. Copa is an ideal strategy to benefit from the growth in Latin America without having to select the right industry. Copa success can be attributed to two key strategies, expansion of destinations and fuel efficient planes. Most recently, Copa began serving Tampa, Florida, its 66nd destination. The fleet has an average of just over four years and consists mostly of Boeing 737’s. By operating newer, more fuel efficiency planes, Copa has a competitive advantage over competitors operating older “jet fuel guzzlers.”
United Natural Foods (UNFI $68) – United Natural Foods is the largest distributor of organic, gluten free, and non-genetically modified foods in the U.S. Approximately, one-third of sales are to Whole Foods Markets. Other customers include supermarkets and smaller, boutique independent stores. In addition, Naples clients may recognize the Earth Origins store which Natural United Foods employees as a “research & development” site. The sales growth of natural foods continues at a strong pace and United Natural Foods is at the core of this trend. Recent financial results took an uptick due the efficiencies gained from new, very efficient warehouses, and an example of the positive use of technology.
Information sources used to prepare this report include Argus Research, Value Line Investment Survey, Zacks, Barron’s, Kiplinger’s, Fidelity, and Decision Economics.
Founded in 2010, Andrew Hill Investment Advisors, Inc. is registered as an investment advisor with the state of Florida and only transacts business in states where it is properly registered, or is excluded or exempted from registration requirements. Andrew Hill and clients of AHIA hold positions in the investments mentioned in this report. Please contact Andrew Hill Investment Advisors, Inc. if there are any changes in your financial situation or investment objectives, or if you wish to impose, add or modify any reasonable restrictions to the management of your account. Our current disclosure statement is set forth in Part II of Form ADV and is available for your review upon request. Tax and estate planning advice is general in nature and the firm is not engaged in the practice of law.