December 6, 2012
Dear Friends & Clients: Let’s talk about your investments, what’s going on in the economy, the markets, SRI, etc.
If you are well diversified into SRI stocks (domestic, foreign, large and small-cap) and bonds, over the last twelve months your overall portfolio has probably experienced an internal rate of return about one-third to one-half of the upside of the S&P 500, which is a pure large-cap domestic stock index.
This should not surprise you. As we have discussed in the past, diversification that includes both stocks and bonds should underperform during upturns and outperform (fall less sharply) during downturns, and that is exactly what has been happening. From the market bottom in March, 2009, until March of 2012, the stock market rose in a typical recovery pattern. Since then the large-cap domestic stock market has been very volatile, but has only gone sideways.
In 2007-2009, when the stock market fell 54%, if you were diversified your account fell less than the S&P’s drop of 54%. Diversification helped. Now that the economy is recovering your account is rising slowly, more slowly than pure stocks. The most commonly used foreign stock index, the EAFE index, rose only a third of the S&P 500. The Barclays Aggregate Bond Index rose one sixth as high as the S&P.
As we have discussed before, the asset class with the greatest risk right now is long-to-maturity bonds. When prevailing interest rates rise, the longer bonds tend to lose value. The only way to limit that risk is to keep your bonds “short” to maturity, and, while this keeps that portion of your portfolio stable, it lowers your bond interest compared with the aggregate index.
We are currently in one of those periods in which SRI has underperformed conventional investing, with the SRI index coming in at about 2/3 of the S&P for the last twelve months. Now, every strategy has its time in the sun and its time in the clouds. SRI is no different. Since its inception in 1990, the primary SRI stock index, the DSI 400, has outperformed the S&P 500, on average. There will always be shorter periods, such as the one we are in, when SRI underperforms. This is usually true during times of war and rises in the price of oil, but the biggest difference this year is that our portfolios don’t include Apple Computer while many conventional portfolios do. Apple is so huge that it is nearly single-handedly boosting the conventional indices it is in. Is Apple a bubble, about to fall as it has risen? Not necessarily, but I doubt it can continue to grow as it has over the last couple of years.
Should you have put your entire portfolio in large-cap stocks a year ago? Hindsight says “yes,” but do you remember the risks in the economy back then? It was a scary time for stocks. Both political parties seemed willing to drive our economy off a cliff to win the election, and dissolution of the European Community and currency seemed imminent. Many of you were doubtful when I suggested that we were already in a recovery. Many conventional investors took their entire portfolios to cash. Had the markets crashed back then they would have said that a coming downturn had been obvious, and weren’t they smart. Instead, they have missed the recovery, so far.
And what about the so-called “Fiscal Cliff?” Like so many of the Republican framings, this one is intended to provide cover for cutting discretionary and “entitlement” programs. How did they make “entitlement” a bad word? Aren’t we entitled to it because we’ve paid for it? Now that’s successful framing.
There is no Fiscal Cliff. The higher tax rates will take a year to work their way into our economy. Ditto with the cuts in programs, such as the military and federal agencies. Maybe there will be a “Fiscal Slope.” Obama and Congress will have a few months to fix this. Once that happens the uncertainty should be over and I imagine that worldwide stock markets may respond enthusiastically. If we do not have a budget deal Congress by December 31st, the stock market may fall a bit, but the slump should be short-lived.
What should Obama and the Congress really be doing about our debt and recession? First, the debt isn’t the problem both parties are making it out to be. Interest payments on the debt, that’s the difficulty. Coming out of WWII the Federal debt was something like 136% of GDP. Keynesian stimulus (like the GI Bill) enabled us to grow out of most of the debt. We shouldn’t eliminate public and private debt entirely, since that’s our money supply. What Congress should do is print the money we need to solve our problems with Medicare, Medicaid and Social Security. Not borrow it – print it. The Federal Reserve has been creating plenty of money, but the banks are holding on to it instead of lending.
So, what are your options as an investor now?
Well, one possibility is getting rid of some or all of your bonds (for the time being). Our chief bond manager calculates that if/when prevailing interest rates recover to their historical average level, the longer-duration bonds could lose more than 40% in market value (which is why he is keeping most of our investors’ bonds short-to-maturity). Keeping your bond durations short means that they protect their part of your portfolio, but short bonds yield less interest than the rate of inflation, slowly hemorrhaging value. Do keep in mind that shifting your allocation from bonds to stocks increases risk, too.
So, right now you get to choose your risks. There is the risk of underperformance (keeping your current allocation to short bonds) vs. the risk of having too much of your portfolio vulnerable to market moves (by moving money from bonds to stocks). Please call me and let’s discuss this.
We really dodged a bullet last November 6th, didn’t we? While I may not be thrilled with President Obama, I certainly did not want the Republicans shifting the Supreme Court further to the corporate right, a terrifying possibility. As for the Affordable Care Act being called “constitutional” by the Supremes, I really nailed that one, didn’t I? If you don’t remember, I invite you to revisit my 1st Quarter newsletter of May 28th, 2012. Chief Justice Roberts threaded the needle exactly along the lines I described.
What can we do politically? On the larger issues, we are powerless in the face of the fantasy world agreed upon by both parties, so I think we should focus on what is actually accomplishable and might provide a wedge that would make a difference. Let’s see if we can get a Single Payer plan instituted in California and a State Bank. And let’s see if we can get our President to support organized labor, as he promised he would (and has not).
Taxes? Those heartless Democrats are very likely to raise the tax rates on Capital Gains. Additionally, a Medicare surtax on investment income kicks in next year. See? Maybe we all should have voted for Romney. (-; OK. Not funny.
Seriously, please discuss this with your tax preparer as soon as possible. Should we be selling a bunch of your stocks which have unrealized capital gains before the end of this year in order to realize those gains at the current capital gains tax rate, rather than waiting for the rates on capital gains to rise, probably next year?
That’s enough for now.
Remember to raise hell and have a good time. I hope you are well and thriving.
Up the Rebels!!
Lincoln Pain, CFP®, AIF®
Effective Assets™ is an independent registered investment advisor (RIA) registered with the State of California.