Over the last three months we have transitioned through concerns of when the Federal Reserve would begin tapering its monthly bond purchases to dealing with political battles on Capitol Hill about spending, the debt ceiling, and The Affordable Care Act. We have seen this movie before but each time it seems to have a new twist. As we write this letter, the government has “shut down” because the House and Senate will not agree on a spending bill. Today's government shutdown is the 17th in the last 100 years, with 16 of those occurring since 1976! We are not overly concerned about a shutdown or its impact on the economy; however, the upcoming debt ceiling debate and the corresponding uncertainty has the potential to rattle markets and impact our overall credit rating as a nation. We take that situation quite seriously, though we believe a credit default by the U.S. government can and will be averted.
In other news, the economy maintains its slow march forward. When reviewing the various components of GDP, we see contrasting trends: the private sector is growing nicely, adding to GDP while government spending has declined rapidly causing a drag on GDP. GDP for Q2 came in at 2.5% which reflects this dichotomy of a growing private sector and a shrinking public sector. That private sector growth has not yet translated into strength in hiring. In contrast to prior recoveries, employers have been content to hire fewer workers because growth has not been robust enough to justify large workforce increases. As a result, many workers have simply stopped looking for employment and therefore dropped out of the labor force. This artificially lowers the headline unemployment figures.
Recent data continues to point to economic improvement for the remainder of this year. The Conference Board's Index of Leading Indicators increased 0.7% in August which is expansionary. Data on existing home sales, durable goods orders, and personal income are all encouraging signs. Please don’t misunderstand though, “encouraging” is not the same as “strong.” As we’ve often stated, growth is the key to our economic and political issues and while we’re headed in the right direction, we need to see more.
One way the recent rise in interest rates has impacted the economy negatively is the effect on the affordability of housing. We saw this impact in the housing numbers through the summer. In addition to a rising interest rate environment, new home construction has experienced a labor shortage – workers from the boom years have moved on to other jobs. All of these factors lengthen build times for homebuilders and have kept housing starts in check over the last quarter. However, we continue to believe our thesis driving the housing recovery, namely, pent-up demand and relative affordability are still in place.
Stocks closed out the third quarter with another gain; the S&P 500 returned 5.2% for the quarter and is now up 19.8% year to date. As we have said all year, the market has moved very far, very fast and the economy needs time to catch up. While we don’t think the market is wildly overvalued here, we think current prices reflect a fair valuation. We think volatility is set to increase with the debt limit debate. As we have mentioned in prior letters, volatility is the stock-picker’s friend in that we hope to find attractive entry points to purchase the companies that we’re following.
In the third quarter eight of the ten economic sectors in the S&P 500 posted positive returns. The largest gains came in the Materials, Industrials and Consumer Discretionary sectors. Conversely, Telecom, Utilities and Consumer Staples sectors led to the downside. Much like the second quarter, we explain the decline in these three sectors by the close ties to the 10-year Treasury. These three sectors have the highest dividend yield and are often treated as a proxy for bonds by some investors.
It has been a stellar year in stocks, with most stocks fairly correlated to the upside. While we believe that the market is reaching close to what we perceive as fairly valued, it does not mean there are not good deals on stocks. It is times like these where picking individual stocks using a valuation process adds tremendous value. Remember that when you buy a broad based index fund, you own everything; the cheap stocks and the expensive stocks alike. By purchasing companies trading at a discount, it provides the opportunity for outperformance over the index in times such as these. To summarize, we believe “stock picking” has come back into favor and should play a greater role in future returns than it has in the last few years.
We also continue to keep an eye on major domestic and geopolitical issues which could cause future shocks. The list hasn’t changed much form last quarter with the exception of domestic politics.
- Perceived tightening actions from the Federal Reserve (interest rates have moved up, but we are still waiting for first “taper”)
- Political gridlock in Washington on the budget and debt ceiling debates
- A re-igniting of the European Debt Crisis (Portugal this time?); Europe continues to pull out of recession
- The Affordable Care Act sticker shock and its effects on consumption and employment (answers coming soon)
As we discussed in our last letter, the May 22nd “tapering” speech given by Ben Bernanke drove dramatic moves in the yield curve. At the time of the speech, the 10 year Treasury was yielding approximately 1.6%. In early September, it reached a high of 3.0%. This move in interest rates happened much quicker than most investors expected. Concurrently, bond prices fell precipitously especially on the long end of the yield curve.
Due to the uncertainty surrounding the Fed’s plans and issues such as the Detroit bankruptcy, municipal bond prices fell more than the comparable Treasury. We are buying bonds with yields we have not seen in quite some time. Our approach is to buy high coupon callable bonds with a short call feature (5-7 years) and a longer dated maturity (10-15 years). Buying this structure is defensive in nature considering a potential rise in rates. If rates stay low or increase slightly, these bonds should be called away. If rates rise beyond the stated coupon, the bond will go to the end maturity which translates into a higher annual yield. The yield curve is very steep right now and our strategy of buying in the steepest part of the curve has not changed.
In the taxable market we are utilizing a modified barbell approach. On the short end of the yield curve, we are buying corporate credits that provide a slightly higher yield than government Agencies. For the middle to long portions of the yield curve, we are using callable government agency bonds with “step up” coupon structures. These bonds provide a unique structure where the coupons increase over time; this structure should help insulate these bonds from the effects of rising interest rates. In aggregate, this barbell strategy results in a portfolio with a duration (interest rate risk) lower than the market which is defensive should rates continue to increase. If rates rise we will have the short corporates maturing which provide capital to redeploy at higher rates.
Even with the potential short term volatility due to political standoffs, we do not believe we can accurately predict short term moves in stock or bond prices. While we would not be surprised if we have already seen the highs for the year, we have seen enough economic momentum to support our conviction that investing in the right mix of stocks and bonds will yield ample appreciation in the years to come. While the short term is hard to quantify, the long term is easier for us to see, so we continue to strive to prudently manage potential outcomes.