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August 2013

Is the Bond Bear Finally Here?

As we have seen for the last few years, the stock markets were off and running in the first quarter only to hit a snag and pull back in the second quarter. What is different this time is that Ben Bernanke has put investors on notice that the Federal Reserve is going to start tapering off its Quantitative Easing. Many see this tapering off as a signal that interest rates will begin to rise, triggering a bond bear market. In this MarketView we will examine the returns for the quarter and explore what a bond bear market likely means for investors. Much to investors’ chagrin, the stock market doesn’t just go straight up. There are ups and downs and sideways movements, accompanied by periods of extreme volatility followed by periods of muted volatility. Often times the changes seem to come much like a restless sleeper who has been tossing and turning all night, and when he/ she finally gets comfortable and settles in for a good sleep, the alarm goes off.

That’s the stock market. Just when we start to think we won’t have to worry about volatility anymore, the markets make a big move and volatility increases. Or when the pundits begin to tell us that the markets can continue to move higher without a meaningful pullback, we get blindsided with a 300+ drop in the Dow Jones. This was the case in the second quarter. The markets were continuing to climb higher, the economy appeared to be improving, and Mr. Bernanke announced that the Federal Reserve would begin to reduce their purchasing of U.S. Treasuries. This news didn’t sit well with investors and they responded by selling their positions. From an advisor’s perspective this sell-off was much needed to keep the markets healthy, and when it was all said and done, the U.S. markets and the international markets, represented by the MSCI EAFE, posted positive returns for the quarter. Europe, Emerging Markets, U.S. bonds, real estate and gold posted negative returns for the quarter. The S&P 500 Index total return was

2.92% for the quarter, the Dow Jones Industrial Average came in up 2.91%, the MSC I EAFE posted a 2.98% return and the NASDAQ led the way with a 4.15% return. On the downside the MSCI Emerging Markets index was down 10.89% for the quarter and the U.S. Barclays Aggregate Total Return index posted a negative 2.33% for the quarter. REDW Stanley strongly believes in asset allocation and diversification. Like any strategy there are times when it doesn’t work out in the short-term, and the second quarter is an example of diversification not working out. Our exposure to emerging markets, Europe, real estate and bonds hurt us in the second quarter, but we are still confident that the benefits of controlling risk and volatility with diversification will pay off in the long run just as it has in the past. Now let’s take a look at the pending bond bear market. The very first thing that needs to be clarified is what “tapering off ” means. The Federal Reserve has been buying intermediate term U.S. Treasury bonds to help keep intermediate term rates low. Bernanke is suggesting that if the economy continues to improve, the Federal Reserve would slowly reduce the amount of U.S. Treasuries it is purchasing. There was no commitment to raising interest rates at the last Federal meeting, but of course if the economy continues to improve, the expectation is that short term interest rates will rise, causing bond prices to go down. However, rising rates are not always bad for the stock market. In fact research indicates that in low interest

rate environments with increasing rates, the stock market actually does quite well. See the first chart on page 3. As you can see by the chart, when interest rates are below 5%, rising interest rates are generally associated with rising stock prices, and interest rates are well below 5%. With all of the chatter on the airwaves about bonds being in a bubble and interest rates having to rise, I’m sure readers and investors are still skeptical that everything will be all right, and we certainly cannot guarantee that they will, but we believe that with the recent environment of historically low interest rates and the current environment of very low interest rates, a return to the norm will be a good thing in the long run. Of course, in the investment industry making prognostications without supporting documentation is almost meaningless unless you are Warren Buffet or Bill Gross with PIMCO, so let’s look at the last three times interest rates have increased—or what we will call the last three bond bear markets. First, let’s define a bear market for bonds as an extended period of short-term interest rate increases starting with the first increase in Federal funds rates and ending with the last increase. Second, let’s define Fed funds rate: this is the interest rate charged by banks with excess reserves at a Federal Reserve district bank to other banks needing overnight loans to meet reserve requirements, making it the most sensitive indicator of the direction of interest rates. Now that we have defined a bond bear market and the Fed funds rate, let’s take a look at the last three bond bear markets as promised. From 2/4/94 thru 2/1/95 the Federal Reserve increased the Fed funds rate seven times. The largest of those increases was 75 basis points (bps). The return on the Barclays U.S. Aggregate Bond Index for 1994

was -2.92%. The return the next year in 1995 was 18.47%. So while 1994 wasn’t good, it certainly wasn’t catastrophic. Interesting, but not convincing. The next bear market occurred between 6/30/1999 and 5/16/2000. The Federal Reserve raised the Fed funds rate six times with the largest increase being 50 bps. The return on the Barclays U.S. Aggregate Bond Index was -0.82% for 1999 and 11.63% for 2000; once again, not as bad as one would imagine with rising interest rates in effect. I’m sure there are some of you who are still not convinced that everything will most likely be fine, so let’s look at the last bear market. This took place from 6/30/2004 through 6/29/2006 and the Federal Reserve increased interest rates SEVENTEEN times, all by 25 bps. The returns on the Barclays U.S. Aggregate Bond Index were 4.34%, 2.43% and 4.33% for 2004, 2005 and 2006, respectively. When the Fed finished raising interest rates in 2006, the Fed funds rate stood at 5.25%, and right now it stands in an official range of 0% to 0.25%. As you can see, rising interest rates don’t necessarily spell doom in the long term, and as advisors, REDW Stanley falls back on the same advice that we give when we are talking about stocks and how the stock markets behave. In the short term, rising interest rates will cause a decrease in value to your bonds and bond funds, but long term, everything should be fine as we return to a normal market with a normal level of interest rates and higher yielding bonds. Also, we want to emphasize that a bear market in bonds is nothing in terms of magnitude compared to a bear market in stocks where we have seen negative returns of 30%, 40% or even 50% on some stock indexes in the past.

The other concern with an improving economy is inflation. Right now there are no real signs of inflation, but just like interest rates, increasing inflation is not always a bad thing, particularly when inflation is very low. The second chart on page 3 shows that there have been seven times since 1972 that we have had low but rising inflation. The average return for the S&P 500 during those periods has been 20%. That chart also shows bonds returned an average of 6% during those same periods, reinforcing the fact that rising rates don’t necessarily mean that bonds will perform poorly in all circumstances. In previous MarketViews we have reiterated certain themes—one having to do with fundamentals and another having to do with taking a long term approach—and we still stand by these themes. Interest rates have been very low for years now and a return to the mean interest rate levels will make the bond markets fundamentally sound, which is a good thing. Retired people depending on interest distributions might be able to garner a decent return from their bonds sometime in the future. And like the stock market, a shock to the system—in this case in the form of rising interest rates—generally has a short term negative effect, but in the long term the bond market adjusts and returns to profitability. Remember that emotions move the market in the short term, but fundamentals move it in the long term.

By Jude V. Gleason, CFP®, AIF®, MBA Chief Investment Officer

2 Copyright 2013 REDW Stanley Financial Advisors, LLC. All Rights Reserved. This publication is intended for general informational purposes only. The information contained does not constitute legal financial, accounting, or other professional advice.

3 Copyright 2013 REDW Stanley Financial Advisors, LLC. All Rights Reserved. This publication is intended for general informational purposes only. The information contained does not constitute legal financial, accounting, or other professional advice.

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Market View (Aug 2013)  

Review of 2nd quarter market performance