The Blatt Watch by Peter Blatt: Why Do The Markets Drop?

From the desk of Peter Blatt

How is your financial planning?

Sometimes markets fall. One of the worst strategies is to buy and hold investments.  An actively managed conservative portfolio should out-perform a buy and hold stock portfolio in a declining market. The commentary below is from one of our trusted Advisor’s at Global Financial.

Tapering

Synopsis

• Short term volatility spiked recently over concerns that the Fed may begin a process called tapering, or reducing its bond purchasing program meant to keep short-term interest rates at zero.
• We anticipated many of the market movements that are currently underway, and as a result, we were able to avoid much of the selloff sparked by this rise in volatility.
• Despite investor concerns, we see no credible evidence in a shift in strategy from the Fed, and hence, we continue to expect the war on seniors and savers to continue.

Short-Term Volatility is Back
Short term volatility spiked recently due to fears that the Fed may scale back their bond-purchasing program known as Quantitative Easing (QE) earlier than initially expected. The Fed has used QE to maintain a zero interest rate environment (ZIRP), and any sign of the Fed reversing course and raising interest rates poses risk to investors holding longer dated maturity bonds.

Take the long dated Treasury bond index for example. Since the beginning of May, investors holding long dated treasuries have faced one of the steepest price declines in decades. The chart below shows that longer dated Treasuries, in addition to defensive sectors such as telecom and utilities, have suffered since the beginning of May.

Instead, our fixed income holdings consist of strictly high quality, short maturity bonds. This strategy has insulated us from much of the weakness experienced in the bond market over the past several weeks.

NOTE: Bonds with longer maturities tend to suffer more than shorter maturities in rising interest rate environments because investors want to get their money out of older bonds that pay lower rates and into newer issues with the higher rate. Since longer maturity bonds pay back the principal further down the road, they pose greater reinvestment risk and subsequently face steeper price declines as rates rise.

Now let’s focus on other asset classes. The rise in bond yields also affected other income producing securities including preferred stock, floating rate funds, and equities in defensive sectors such as utilities, telecom, and consumer staples. Stocks in these sectors were hit particularly hard given their meteoric rise through the first quarter of 2013, and we feel that many investors were simply looking for a reason to sell and take profits.

We also anticipated this leadership change in the equity market, and as a result, we had already reduced our exposure to the sectors that are suffering the most right now.

We See No End in Sight for QE
There is no question that much of the economic data released over the past two weeks indicate that our economy is moving in the right direction. Consumer spending comprises roughly 70% of GDP and sentiment is improving. Additionally, manufacturing indexes indicate expansion which could confirm the theory of many that companies are beginning to build inventories and spend more money.

However, we believe that we are 2- 4 years away from any real move by the Fed to reduce its bond purchasing program, a process being referred to as tapering, for three key reasons:

1. Unemployment is Still a Problem: The Fed has stated that their main objective is to lower the unemployment rate to 6.5% before they begin tapering. Although the rate has reduced to 7.5% from 7.9% since October 2012, we are a long way from reaching this target.
2. The Devil is in the Details: Digging deeper into the unemployment number actually paints a less optimistic picture, leading us to believe that the decline is fueled primarily by frustrated job seekers leaving the labor pool due to the inability to find work.
3. Bernanke Knows the Score: Ben Bernanke is a student of the Great Depression, and we believe that he is well aware of what can happen when QE is terminated prematurely. We anticipate that he will not change course until he is absolutely certain that the economy is healthy enough to withstand tapering.

The chart below supports our view on why we feel that the unemployment situation has not improved materially. The black line indicates the direction of the unemployment rate and the orange bars represent the size of the overall labor force.

Embrace and Applaud the End of Quantitative Easing
Imagine you hurt your leg and spent the last month in a cast. As helpful as that cast may be while you are recovering from a bad injury, we all know that it needs to come off at some point. Well those first few days walking without a cast on your leg is going to be difficult until you regain your balance and strength, but over time you will be back to normal.

Quantitative Easing has been a cast for our economy and at some point we need it removed. Sure, the markets will need some time to regain their strength and balance, but remember to applaud the day that QE ends for three very important reasons:

1. Quantitative Easing Cannot Last Forever: The short term effects of QE are meant to prop up markets during tough times and cannot sustain a secular bull market. Do you want to wear a cast on your leg forever?
2. It’s Healthy: In the long run, markets should be fueled by real earnings growth and reaping the benefits from investing in research and development.
3. Income Seeking Investors Benefit Greatly: An end to QE will ultimately lead to a rise in interest rates which will benefit seniors and savers. Anyone in search of yield, including CI, should benefit in the long run as rates rise above the rate of inflation.

We Planned for a Pullback
The month of June is an awkward time for a pullback because there are no earnings and few market moving events, so the markets are subjected to conjecture and speculation. As a result, the volatility witnessed recently could persist until we get to second quarter earnings in July.

However, pullbacks predicated upon short term volatility actually excite us because impatient investors tend to run away and subsequently open up wonderful buying opportunities for long term investors. We began building cash reserves back in April for this very reason – to take advantage of fear and panic in the markets and buy securities that go on sale.

Until next time,