Compass July 2013

In this issue:

Compass is the quarterly newsletter of Creekside Partners. All information is obtained from sources deemed to be reliable, but is not guaranteed as to accuracy. Nothing in this newsletter should be construed as financial or investment advice to any reader. All material herein is the copyright of Creekside Partners.

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It’s All About the Fed

As the stock rally rolled forward in the first half of the year, market bulls made the case that, no, the stock market was not built upon the shaky foundation of support by the Federal Reserve’s bond-buying program. No, stocks were going up at a double-digit annual rate completely independent of Fed action. With earnings growing at 2-3% per year, stocks were going up at three times that rate of growth. Yes, that makes no sense. But it’s different this time.

The bulls understand that, mathematically, the logical extension of the argument that stocks can go up faster than earnings growth means that stocks have infinite value* and that no number is too high. They also insist that this has nothing to do with the Fed artificially boosting the market for Treasury bonds and government-issued mortgage bonds.

But then, back here in the real world, the Fed chairman merely hinted that the Fed might possibly slow down its bond-buying. And all heck broke loose. The 10-year benchmark Treasury bond (which rate was already moving higher) lost 3.8% of its value as rates moved from 2.18% to 2.55% in a mere 4 trading days. The stock market also panicked — and sold off nearly 5% in those same 4 days.

Chairman Bernanke then dutifully did what Wall Street needs him to do and made some public remarks to the effect that, no, he didn’t really mean it and we can all just go back to buying stocks. He will remain “highly accommodative.” Stocks promptly hit new highs in July; the types of bonds we own recovered most of their paper “losses.” Crisis over.

Or is the crisis over?

That depends on what you want as an investor, and what you are trying to achieve.

If the driving issue for you is whether or not your portfolio is keeping up with the herd on a short-term basis, then perhaps the crisis is over in the short term. The Fed has propped up your portfolio, and a bet to overweight stocks has been the right bet. You believe that Bernanke will take care of you. For now, anyway, you are with the herd (even it’s headed in the wrong direction).

If this describes you and your confidence in the benign hand of your government, perhaps you are comfortable adding risk to your portfolio.
We are more cautious.

If your driving investment issue is the need to protect your savings, and to provide a good, safe result over the next 3-5 years, then you might pause to think about the implications of the two competing claims about what Mr. Bernanke can and cannot do:

Either he can…
Keep this going forever, or…
He can’t.

Honestly, either of these claims can be true, so let’s look at the respective outcomes. First, let’s say the Fed keeps rates artificially low for a long, long time. The Fed will continue its current policy indefinitely if and only if the economy continues to perform poorly. Now note the conundrum the bulls find themselves in: We think the Fed will keep rates low forever. Which means we like stocks. But that will happen only if the economy does badly. Which means earnings won’t grow. Which means…we don’t like stocks.

Oh, the irony practically screams from the page.

Now, what happens if the Fed can’t do this forever? If the labor market improves quickly, and/or if inflation moves into the politically painful range over 4%, the Fed will either allow rates to rise faster than expected, or the bond market will force it to. As we saw in mid-June, the stock market will not be happy and even the bulls will say, “We don’t like stocks.”

Is there a Goldilocks-type outcome here? Sure! We peg this outcome as the most probable one since it represents a convergence back to normalcy, and such convergences are always the most likely. The labor market and inflation both move smoothly and slowly toward normal and the Fed unwinds its interest rate manipulation in an orderly fashion. Ideally, that whole “glide path” happens over a 2-3 year period.

In which case, our short/medium duration bond portfolios will nicely roll over into higher yields. Our dividend and natural resource stocks should deliver for us as well.

The bottom line here is that a forward-looking, risk-controlled approach to the Fed Problem is to not try to anticipate the timing and scale of Fed actions in the short term. Assume that they will do one thing or the other, and set yourself up to be fine under all outcomes. Wise investing has always taken the longer view, and the longer view assumes that the Fed could do anything, at any time. By sticking to a low-risk, valuation-driven approach, we have far more confidence that we won’t be left sitting on our rooftops like a New Orleans resident post-Katrina — wondering when the government is going to come save us.

For us, that means an underweight to expensive domestic stocks and long-dated bonds. Instead, we favor cheaper global stocks that pay dividends, and short-term bonds with after-tax yields higher than the dividend yields on stocks. Municipal bonds offer a return over the next 5-7 years that is more than twice the rate of inflation, after tax. With no reliance on the Fed to do any particular thing.

This is not the time to add risk to portfolios simply because we think we might be able to outguess millions of other investors about the fickle Fed. We will stick to our principles with a focus on safe and cheap assets.

*If earnings grow indefinitely at, say, 3% per year, then the true fair value of stocks can only go up by 3% per year over time. If stocks rise faster than 3%, it’s because investors are paying an ever-higher multiple of earnings. For that to go on indefinitely, then the P/E ratio goes to infinity. It’s an absurd argument, yet people make it all the time.

Bonds vs. Bond Funds

We’re from the government, and we’re here to help.

Among the more frequent questions we field is: What is the difference between owning bonds and owning a bond fund? A bond fund does behave differently than a portfolio of individual bonds; total returns over any given period can be the same, or spectacularly different. Bond fund results will differ from bond portfolio results due to two factors:

Most bond funds are actively managed and make wholesale changes to their holdings all the time. German bonds yesterday; mortgage bonds today; emerging market bonds tomorrow; etc. Laddered bond portfolios are largely a buy-and-hold strategy using a single type of bond. Therefore, the bond fund might perform better or worse than a laddered portfolio due to the fund manager’s skill at making these bets.

Even passively managed bond funds that do not change their tactics are subject to monies flowing into and out of the fund. In addition, monies from maturing bonds are rolled back into longer-dated bonds within the fund. These factors may or may not be in play in a private investor’s laddered bond portfolio. If rates are rising and new money flows into the fund, older fund investors will reap a benefit. The opposite is true if rates are falling and money flows in.

All told, bond funds do, in fact, perform quite similar to laddered portfolios when measured over a relevant time period. If the bond portfolio has an average maturity of five years, then we have to compare it against a bond fund that is held for five years. When we compare apples to apples, we find they are very close. Investors get confused by the fact that a bond fund will post a new price every day. They wonder if the price will recover over time, the way that individual bond prices do. The answer is, yes, almost all of the time, when the interest earnings are taken into account.

Stock mutual fund prices can go down and stay down. Bond mutual fund prices can go down, but tend to converge back over time and deliver the total yield that was expected when they were purchased.

Some writers and pundits have argued that bond funds are not preferable because their daily price can rise and fall, while a laddered portfolio, held to maturity, will deliver a dollar-certain result. But this is a straw-man argument: It is a fallacy to compare the daily price swings of a bond fund against the long term performance of individual bonds.

We can ask the question, “How close did the bond fund come to delivering what we could have had from a direct portfolio of bonds?”

We undertook to answer this question by comparing the returns on passively-managed bond funds over five-year periods, to the yield on the ten-year Treasury bond at the start of those five-year periods. For each five-year period, we noted the yield available on the 10-year Treasury bond at the start of that period.

We then computed the total return earned on the bond fund over the next five years and compared the ending result with the expectation (10-year Treasury yield) at the time the fund. The chart on the following page shows that, over the vast majority of 5-year periods, the annualized returns of the fund were very close to the 10-year Treasury bond at the time the fund was purchased. The outliers to either end took place during periods when interest rates were rising or falling sharply, with the fund tending to outperform when rates were rising. This, despite the fact that the fund’s share price would have dropped at some time during the five-year holding period.

Why might an investor instead hold a direct portfolio of bonds? Despite the fact that passively managed bond funds can perform similarly to a direct portfolio, a direct portfolio can eliminate the uncertainty almost entirely. If we construct a portfolio of bonds with a weighted average yield of, say, 4%, then that portfolio will, with certainty, yield 4% over its life. A laddered portfolio can also be customized to meet retirement cash flow needs by scheduling maturities accordingly.
Finally, a laddered portfolio allows us to customize the individual bonds to take advantage of specialized market sectors and achieve higher returns. An example of this is the market for California municipal bonds, which is notoriously fragmented and inefficient. On the same day that a state-issued bond yields 2%, we can find equally secure local issuer bonds yielding almost twice that.

In summary, bond funds are a perfectly acceptable substitute for holding individual bonds. We encourage investors to largely ignore the daily price movements of the funds and focus instead on the total return expectation over a longer holding period.


For the bond mutual fund returns, we used the Barclay’s total bond index from 1975 through 2002, and the Vanguard Total Bond Market fund thereafter (since that’s the data we had at hand).

Year to Date 2013 Index Returns

Balanced 60/40 Index

Total Market U.S. Stocks

Foreign Stocks (Developed)

Emerging Market Stocks

Muni Bonds

Taxable Bonds

Inflation
Trailing 12 months

4.82%

14.04%

3.38%

-10.88%

-2.33%

-2.54%

1.5%

Wherever possible, we use the returns on Vanguard Index Funds as the benchmark figures for various asset classes.

Readers wishing to review the actual performance record of a composite of our client portfolios should call or email us at info@creeksidepartners.com.