Second Quarter 2014 Investment Commentary

Most financial asset classes performed well in the second quarter. The Vanguard S&P 500 Index fund was up 5.2% for the quarter and 7% for the year to date, after rising more than 2% in June. Smaller-company stocks lagged larger-caps during the quarter (up 2.1%) as well as for the year to date (up 3.3%), even after a 5.3% pop in June.

After revisions, the U.S. GDP for the first quarter was a negative 2.9%. That’s the largest drop since the first quarter of 2009. Experts blame a lot of the bad report on the weather (I thought it got cold every winter). Expectations are for growth to rebound in the second quarter; however, the fact remains that the economic recovery continues to be below average.

Stocks in developed international countries were mostly positive. The European Central Bank continued to “do whatever it takes” by reducing interest rates as it tries to overcome concerns about long-term deflation risk. Japan’s prime minister continued his effort to generate healthy inflation and lift Japan’s economy. But despite these efforts, both economies appear to be moderate. Emerging-markets stocks had a poor first quarter but rallied in the second. They were up 7.3% for the quarter and more than 6% for the year. It appears that many experts are concerned about China’s economic outlook but India’s stock market had a big rally during the quarter. There appears to be a lot of high hopes for India’s newly elected prime minister.

As a surprise to many, core bond values also gained as Treasury prices rose and bond yields continued to fall. The 10-year Treasury yield ended the quarter at 2.53%, down from 3.04% at the end of 2013. The Vanguard Total Bond Market fund was up 1.9%. High-yield (“junk”) bonds gained as investors continue to chase yield. Floating-rate loans and municipals also performed well. Mortgage REITS have performed well recently but they are quite volatile. The Fed continued to reduce its monthly bond purchases and continued to inform us that they are in no hurry to raise interest rates, based on the current status of the job market and the outlook for inflation. Even though measures of inflation are rising, it is still below the Fed’s target. The Fed recently reduced its growth expectation for this year a bit.

Investor Complacency

“Volatility in the markets is unusually low…I am a little bit nervous that people are taking too much comfort in this low-volatility period. As a consequence, they’ll take more risk than really what’s appropriate.” This is a quote from William Dudley, president of the NY Fed and its one of a few indications that the Fed is now worried about investor complacency. Dallas Fed president, Richard Fisher is quoted, “Low volatility I don’t think is healthy…this indicates to me a little bit too much complacency that rates are going to stay at abnormally low levels forever”. Of course a significant objective of Fed stimulus has been to encourage (force) savers and investors into higher-yielding, higher-risk investments. Stock and bond valuations have been pushed up a lot in a relatively short period of time even though the improvement in earnings and economic growth has been mediocre. So this is a problem of the Fed’s own making and they can’t have it both ways.

The VIX (a volatility index that measures expected 30-day volatility of the S&P 500) has dropped to the level of early 2007. And it is within about two points of the index’s record low in 1993. A low VIX does not necessarily indicate a stock market correction, it can stay quiet for a long time. But I believe in reversion to the mean. Another indicator of the markets’ state of calm is the recent all-time-low level of the St. Louis Fed Financial Stress Index (it measures the degree of financial stress in the markets based on a compilation of 18 weekly financial market data points). Also margin debt as a percentage of stock market value is near all-time highs. (Margin debt is used by speculators to borrow money to invest in risky securities.)

Of course high stock prices, low volatility and above average speculation indicate a lack of concern about risk. And it is obvious that many investors believe the Fed will continue to support financial markets with accommodative monetary policy. This apparent complacency is cause for concern because it suggests a market more vulnerable to negative surprises. High expectations and risky portfolios make it more likely that there will be a negative shock relative to these market expectations, and the more disruptive it will likely be if (when) the shock happens. Hope is not an investment strategy.

Inflation or Deflation

Either a deflationary or inflationary surprise could be troublesome. In Europe, core inflation fell to a year-over-year rate of 0.7% in May. Several smaller European countries are in outright deflation. The latest CPI number was in line with consensus expectations. The European Central Bank initiated new monetary policies in June in an attempt to help reflate the economy, and also signaled that it would act more aggressively if necessary to prevent a deflationary shock in Europe from happening.

Deflationary and inflationary risks seem to be more balanced in the U.S. Even though it appears that inflation (and inflation expectations) remain under control, it has recently been ticking higher. Core CPI hit 2% in May. There are several statistics used to measure inflation. The one that the Fed focuses on the most, the core personal consumption expenditures price index, rose to 1.5% in May—still below the Fed’s long-term inflation target of 2%. Several economists have pointed to the acceleration in the inflation rate over the past year as an indication of a trend. For example, core CPI has increased at a 2.8% annualized rate in the past three months, compared to the 2% trailing 12-month rate.

Inflation is not just mechanical, it’s also psychological. If people lose confidence in the government that prints the money, then it seems logical that the money will lose value. So an important question becomes: is the world’s confidence in the U.S. government growing or shrinking? Hmmm

Monetary Policy

Fed stimulus has obviously pushed up financial market returns in recent years. The Fed has pushed down interest rates to zip, driving down bond yields and pushing up stock and bond market valuations. They have conjured up the most money in the shortest time in history. They have systematically overridden the price mechanism. Prices should be discovered by market participants—not manipulated. The trouble is that manipulating one set of prices causes distortions in others. Unintended consequences will arise.

According to documents from the June meeting, the Fed is about ready to call it quits on the latest round of bond buying. Their trillion-dollar effort to shore up the economy will probably come to a close in October. For the past year and a half, the Fed has been buying tens of billions of dollars in government bonds and securities each month to keep rates down and goose the economy. This has been the third and largest of the Fed’s bond-buying programs since the 2008 crisis. And it seems that they began this (their most aggressive) monetary stimulus at a point where markets had already recovered from the 08-09 crisis and where investors were already complacent. Nobody knows what the unintended consequences of these actions will be. But, regardless of the uncertainties, both the intended and unintended impact on investment markets must be taken into account in order to manage our investment portfolios well.

Low interest rates have helped banks, real estate, the stock market and rich people. But (to my knowledge) the Fed has never given the public an estimate of the cost of the zero interest rate policy. estimates that $100 billion a year for the past five years is the amount bank depositors would have earned, but did not because of ZIRP.

The Global Economy

It appears that the overall estimates of global risks and returns across the major asset classes has not changed much in the past few months. Experts still think the U.S. as well as the global economy is on a slow path of recovery. The financial status of the private sector continues to strengthen resulting, at least in part, from the U.S. household and financial system deleveraging that has occurred since 2009. This lessens the odds of another financial crisis and helps support a fair value for the stock market.

But in just the past few days, there was concern about the condition of a major financial institution in Portugal. This obviously brought back memories about the recent financial problems in the area. Global stock and bond markets reacted quickly and significantly to the down side. The Portuguese Prime Minister quickly went to work to calm fears. But if the perceived risk had carried through, markets would probably have dropped significantly. So we can be sure that global risks remain.

There are about 8 times as many hedge funds walking around today as there were 20 years ago. Hedge funds use several different strategies, including lots of leverage, but a favorite is the “macro” strategy. In order to be successful, a macro investor must predict global economic changes that are really hard to predict, like interest rates, GDP growth, currency values, etc. And they also have to predict market participants’ reaction to those changes as well. According to the HFRI macro index, these funds have produced a compound annual growth rate of 2% since the end of 2007.

GDP growth for the U.S. was only 1.9% in 2013 and, as indicated above, it fell at a seasonally adjusted annual rate of 2.9% in the first quarter of this year. But estimates going forward are in the 3% to 4% range.

Maybe I’m just grumpy but it appears that we are being given some sugar-coated information. For example, the jobs report for June indicated that a whopping 288,000 jobs were created. Earlier this month, the president boasted that the jobs report “showed the sixth straight month of job growth”, and “make no mistake” said he, “We are headed in the right direction”. You would think these are all full-time jobs…but wait, there’s more. Full-time jobs last month fell by 523,000. What increased were part-time jobs by about 800,000 to more than 28 million. It appears to me that what we really have is lower pay, diminished benefits and little job security in too many cases. Only a bit over 47% of adults in the U.S. are working full time. About 2.4 million Americans have become discouraged and dropped out of the workforce.

Asset Allocation

When I talk to clients or write a note, I try to be optimistic and join the mainstream media. But when I surround myself with research in which I have a lot of confidence, it just doesn’t work out. When I read good unbiased research I come to the conclusion that we have been in a fed-induced rally since 2009. I see that a lot of the earnings improvements are the result of unsustainable business cost cutting efforts rather than increases in revenue. I see estimates that about two-thirds of last years’ stock market return was from margin expansion—an increase in the price investors are willing to pay rather than an increase in value. Also, I see that another reason for the increase in earnings per share is that corporations have been aggressively buying back the stock. This results in fewer shares outstanding which causes earnings per (outstanding) share to be higher. It seems to me that stock prices have been pushed up because of a lack of investment alternatives, not because of great economic news.

But it appears that the “risk on” investment environment continues in spite of the warning signs related to global economic growth and financial markets. I continue to be cautious but I’m working hard to generate decent returns while managing risk. This environment may continue for several more months or quarters. But I don’t think relying on central bank generosity is a sound investment strategy over the next five years or so. I have already positioned our portfolios for the likelihood of rising interest rates and some increase in inflation. Overall, our portfolios continue to be somewhat defensively positioned. I am prepared to make significant changes if a market shock appears imminent.

In the U.S. and developed international markets I favor larger-cap, high quality stocks. Small-cap valuations are quite high compared to history and compared to larger-caps. The value style has performed better than growth recently and I expect that to continue.

More than half of our fixed-income exposure is in funds that have significant flexibility to manage their inflation and interest-rate risk (i.e., duration) and other risk exposures as compared to “core” investment-grade bond funds. With yields low and the interest rate and inflation risk high, I don’t have high hopes for bonds. I am also quite concerned about potential liquidity challenges in the bond market. Due to ZIRP and the related yield chasing, some bond funds have huge holdings in low quality fixed income securities with poor liquidity. If (when) a shock occurs, to whom will they be able to sell these securities as fund holders demand their money back? (The PIMCO Total Return Fund had $4.3 billion in redemptions in May.)

I’m maintaining a reasonable allocation to alternative strategies funds. These include lower-risk strategies such as various types of arbitrage. These strategies are intended to generate long-term returns that are better than core bonds, with much lower downside risk and volatility than stocks and relatively low or no correlation to the stock and bond markets. Although the expenses are relatively high, I expect the best ones to provide diversification and risk management benefits.

Thank you for your confidence in me and for the opportunity to serve. I welcome your comments and criticisms.

Take care,


Trust in the Lord with all your heart and lean not on your own understanding; in all your ways acknowledge Him, and He will make your paths straight….Honor the Lord with your wealth…then your barns will be filled to overflowing…. Proverbs 3: 5-10

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