Letter to Clients: 4th Quarter 2013
Dear Clients & Friends: Is it just me, or does each passing year seem to go faster and faster? It is hard to believe that we are entering the final quarter of 2013. Soon the holidays will be over and it will be 2014. Let’s take a moment to examine market performance, discuss the elements of an effective plan, ask if bonds are too risky or if stocks are set to fail, and conclude with what all this means for your portfolio. But before we do, I have some exciting news to announce.
Until now, we have never had the resources to address insurance needs like auto and homeowners for individuals and commercial liability for business. Today we are proud to announce DV Property & Casualty, a new joint-venture between DV Financial LLC and Van Gorp Insurors. Ltd. from Pella, IA, is open for business! We are an independent agency, not tied to any particular insurance company, providing you choice in products and prices. Risk management should be an essential part of your financial plan. Because of our existing relationship, we are uniquely positioned to assess your insurance needs. We welcome the opportunity to serve you in this capacity too.
We are also happy to report that the upgrades to our email server have been completed and we now have the capacity to securely send sensitive information via email. The secure system is pretty easy to use, but if you receive a secure email from us and need help to access it just let us know.
Update on Market Performance
Despite turbulence from economic and political events, U.S. and global stock markets built on the positive returns of 2012, with the exception of soft performance in emerging markets.
In a testament to the resilience of companies and the economy as a whole, this strong performance came in the face of headlines dominated by big picture economic and political uncertainty.
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The possibility of rising interest rates:
The first quarter saw strong gains after agreement by U.S. Congress in early January to avoid the “fiscal cliff” that would have required dramatic reductions in spending and risked throwing our economy back into recession. Then in May stocks and bonds entered a period of uncertainty after indications from Federal Reserve Board Chair Ben Bernanke that given signs of a recovery by the economy there would be a tapering in measures to keep interest rates low.
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Challenges for Europe and emerging markets:
While there were signs of improvement in Europe, the pace of that recovery continues to be disappointing. And as the International Monetary Fund continued to reduce forecasts for global growth, stocks in emerging markets underperformed and countries such as India saw their currency under downward pressure.
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Renewed conflict in Washington:
In early October, we once again saw a stalemate in Washington, with uncertainty about raising the ceiling on U.S. Government debt resulting in furloughs of non-essential government workers and the risk that America will go into technical default on its debt.
Elements of an Effective Investment Plan
An effective investment plan should be long term and look past short term issues such as we’ve seen this year. In developing that plan, our first step is to establish portfolio parameters based on each client’s return requirements and risk appetite. In a 1963 talk, Benjamin Graham, the Columbia University professor whose students included Warren Buffett and who is considered the father of value investing, had this to say about portfolio construction:
“An investor should maintain at all times some division of his funds between bonds and stocks. My suggestion is that the minimum position of this portfolio held in common stocks should be 25% and the maximum should be 75%. Any variation should be clearly based on value considerations, which would lead him to own more common stocks when the market seems low in relation to value and less common stocks when the market seems high.”
That suggested range sets very broad parameters and yet today, some investors resist owning any bonds, while others are out of stocks due to concerns about them being overvalued. Let’s review the issues around bond and stock valuations.
Are Bonds Too Risky?
Some investors have read descriptions of bonds as today’s riskiest asset class and certainly a significant increase in interest rates would create challenges for bond investors. Even in today’s environment, we believe Benjamin Graham’s advice is still wise as long as we expand our focus from only bonds to the broader perspective of income producing investments which can provide insurance against severe volatility in stock prices. Investors may find better yields and stability in alternative investment vehicles.
There are even some who would argue that the concern about the impact on bonds if interest rates rise may be exaggerated. They believe weak economic growth will result in low interest rates continuing for many years to come. One such view comes from Bill Gross of Pacific Investment Management, today’s best known bond manager, who in a recent commentary, predicted that today’s low rates will be with us until 2035. With all due respect for his knowledge and expertise, we interpret his perspective as extreme.
To be clear, we are not recommending overweighting bonds in portfolios and believe that for long-term investors stocks provide better prospects. But we do recommend that clients adhere to some allocation in income producing assets.
Are Stocks Set to Fail?
The flip side of anxiety about rising interest rates for bonds is fear that the run-up in stock prices makes them vulnerable to a severe correction. Some of those concerns are based on work by Yale’s Robert Shiller who claims that based on multiples of 10 year earnings U.S. stocks look expensive. While there could certainly be a short term correction in stock prices, we continue to recommend that clients have a healthy stock allocation in their portfolios:
- Nobody has demonstrated the ability to predict short-term movements in stock prices – it is just as likely that stocks will rise by 20% as decline by 20%.
- A recent article by Wharton’s Jeremy Siegel, considered today’s leading stock market historian, suggests that accounting write-offs by American companies have distorted reported earnings and that if another measure of profits is used stocks are fairly valued.
- Siegel further points out that when interest rates are low as they are today, historically multiples of earnings have been higher than average.
- Finally, for investors concerned about valuations on U.S. stocks, there are high quality companies in Europe and Asia that sell for a significant discount to their U.S. equivalents.
Sticking to Your Plan
“For every complex problem, there is an answer that is clear, simple and wrong.”
H.L. Mencken, 20th century American journalist
“Everyone has a plan until they get punched in the face.”
Mike Tyson, former heavyweight champion of the world
Most investors might nod their heads to facts such as the ones above and can agree to a plan for their portfolio, identifying the parameters within which their investments will be managed. Of course, agreeing to your plan is the easy part – the challenge is sticking to it. As former heavyweight champion Mike Tyson pointed out, It’s easy to keep to your plan when things are going well; it’s when investors get bloodied from market setbacks that sticking to their plan becomes a challenge.
That’s why when markets become choppy, some investors look for bold advice and dramatic shifts in their portfolio, going all to cash or all to stocks. Unfortunately, the track record of those dramatic shifts is not a happy one:
- During the tech mania of the late 1990s, many investors abandoned the principles of sound diversification and over-weighted their portfolios with technology stocks.
- Ten years ago, investors began skewing their portfolios to banks and other beneficiaries of the real estate boom and in some cases extended themselves to buy bigger houses, vacation homes and investment properties.
- While most investors initially agree to geographic diversification of their equity investments, many find it difficult to stick to that commitment. After a period of strong performance such as the U.S. sees today, the instinctive response is often to heavy up what’s been doing well and to abandon what’s been underperforming – when investors should do exactly the opposite.
Recently, deviating from investment plans has taken a new form. Immediately after 2008, a search for safety led to large flows out of stocks and into bonds, meaning that some investors missed the recovery since the market bottom. And to the extent that investors were buying stocks, many only had an appetite for stocks that pay high dividends and are viewed as an alternative to the secure income from bonds.
In the words of the opening quote for this section, each of these examples was seen as a clear and simple answer to the complex problem of where to find the best returns in an uncertain environment. In the search for that clear answer, many investors abandoned the plans that they’d agreed to in calmer times.
That’s why I see my role as an emotional anchor – keeping my clients’ highs from being too high and their lows from being too low. For many clients, helping them adhere to their plan, sometimes against their instincts, is how I provide the greatest value. There are occasions when sticking within the parameters of your plan may feel boring, but history shows that the key to successful investing is having a sensible plan and then sticking to it.
What this means for your portfolio
Throughout the year, we have maintained some guiding principles to follow in 2013, two of which I repeat here.
- Rebalancing Portfolios. At first it seems counter-intuitive. Rebalancing means selling the best performers to buy more of the worst performers. However, systematic rebalancing prevents portfolios from wandering outside of the established investment parameters and fundamentally practices the “Buy Low/Sell High” principal.
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Diversifying your portfolios. Going forward, the dollar and U.S. markets may do better or worse than global markets. However, given that we represent less than half of the investing opportunities around the world, to maximize returns we must be willing to look outside the U.S.
We recognize that today seems like a particularly uncertain time and hope you found this overview helpful. Should you have questions about this note or about any other issue, please feel free to give us a call. Don’t forget, we also welcome the opportunity to serve all your insurance needs as well.
As always, thank you for the opportunity to serve as your financial advisor.
Sincerely,
Art Dinkin, CFP®