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Investment Letter

3rd Quarter 2014

 

October 1, 2014

 

As the summer months slowly fade to fond memories, change is all around us.  Mother Nature is gradually unveiling her colorful autumn masterpiece, the weather is turning cooler, daylight hours are getting shorter, children are back at school, and another exciting football season is underway.  The exuberance in the financial markets waned during the 3rd Quarter after the financial markets posted solid results in the first half of the year. The less than spectacular results changed the financial scoreboard and the Home team is now struggling. 

 

While the Dow Jones Industrial Average (DJIA) didn’t start or end the quarter well, the strong performance during the month of August did propel the index to an all-time closing high on 9/19/2014 at 17,279.74, and helped the index finish the quarter up 216.30 points to close at 17,042.90.  The S&P 500 Index experienced the same slow start and disappointing finish, but it did end the quarter higher and closed at 1,972.29.  In fact, the S&P 500 index broke through the 2,000 point level during the quarter and set another all-time record close at 2,011.36 on 9/18/2014.  Although the quarter return was not spectacular, it was positive and it marked the 7th consecutive quarterly gain for the index.  Unfortunately, not all areas of the market fared as well.  July and September were brutal performance months for domestic small cap and international stocks.  The damage was significant enough to seal their fate as losers for the quarter and year-to-date.  Disappointed investors are hoping for a surge in the final quarter of 2014 that will reverse this momentum.

 

The table below recaps the 3rd Quarter and year-to-date performance of other major indices:

 

Asset Class

Index

3rd Qtr. 2014 Total Return

2014 Total Return

Cash

ML Three-Month U.S. Treasury

0.01%

0.03%

U.S. Bonds

Barclays Intermediate-Term Treasury

0.02%

1.59%

U.S. Large Co. Stocks

S&P 500

1.13%

8.34%

U.S. Small Co. Stocks

Russell 2000

-7.36%

-4.41%

International Stocks

MSCI EAFE (net div.)

-5.88%

-1.38%

Real Estate

DJ Select Real Estate Securities

-3.00%

14.69%

       Source: Morningstar

 

 

Despite the negative returns in some asset classes, the economic news in the U.S. was generally positive.  The -2.9% contraction in economic growth for the first quarter was erased as second quarter growth increased to 4.6%.  The prevailing strength in the economic fundamentals is a positive sign that the five-year economic expansion is still healthy.  Corporate balance sheets remain healthy and profit margins are up. Vehicle sales are holding steady and manufacturing and trade inventories are flat, but the anticipation of stronger demand is high.  The unemployment rate is down to 5.9% (below the 50-year average of 6.1%), inflation remains low, and consumer confidence remains elevated.  Unfortunately, housing activity across much of the country continues to be a drag on the economy, and will keep the expansion from realizing its full potential until conditions improve.   

 

The Federal Reserve continues to take steps toward policy normalization while maintaining an accommodative stance.  During the quarter, the Federal Open Market Committee (FOMC) decided to adjust the quantitative easing program by reducing the monthly bond purchase schedule, reinvest the proceeds of maturing securities, and maintain the current range for the federal funds rate.  The steady and sustained decline of the asset purchase program has reduced the value of Fed purchases from $85 billion in January 2014 to the October 2014 amount of $15 billion (a decline of over 80%).  Expectations are that October will be the last month for the asset purchase program, but the most recent statement from the FOMC stated that “asset purchases are not on a preset course”, and the pace of future purchases will remain “contingent on the Committee’s outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases”.[1]  The Fed will continue their policy to promote economic growth and stability, and all indications lead us to believe that it will be next year before they are ready to start raising the federal funds rate.  However, the FOMC has stated the timing of a future rate hike will be “data-dependent” and not based on a schedule or calendar date.

 

Overall, the economic conditions overseas are mixed.  The pace of growth in the Eurozone remains sluggish and uneven despite fiscal policy support from the European Central Bank. China continues to experience a moderation in economic growth toward a more sustainable level, but the annualized rate of 7.5% for the second quarter of 2014 remains elevated compared to other international economies.  The effect of Japan’s consumption tax on economic growth is diminishing which should lead to a gradual acceleration in the pace of their recovery.  Emerging markets are a mixed bag of treats.  Improvements in many emerging economies are solid while other areas are experiencing further struggles.  Going forward, expectations for growth across most emerging market economies will vary and the pace of growth will be country specific.

 

Our outlook for the rest of 2014 remains positive, and economic indicators suggest the domestic expansion should continue.  We believe there is sufficient slack in the economy for growth to continue at a slow and sustainable level, and our short-term growth expectations are between 2% and 3%.  Normally, we would be elated at the current drop in oil prices as it often equates to an increase in growth.  However, the current scenario might be a little different because the drop in oil prices could be a function of weaker demand instead of increased supply.  Weaker demand would mean another headwind for economic growth.  We are monitoring the recent appreciation of the U.S. dollar versus other currencies and the effect it will have on the economy.  American consumers will benefit from a strong dollar because it increases the purchasing power for foreign goods, but if the appreciation lasts for an extended time, it can have a negative effect on growth as American companies find it harder to sell their products globally. 

 

As the domestic situation enters the later stages of the current business cycle and five-year economic expansion, we are concerned that stock market volatility will become more common due to investor anxiety over the Fed’s policy shift and valuation levels.  Investors have benefited from a stock market that has been undervalued for a long time, but current data shows stock valuations are probably closer to fair value.  Higher valuation levels can send mixed signals to investors as they look to cash out of profitable positions.  In fact, the recent decline in some asset classes could be a shift in investor confidence.  A great deal of uncertainty remains for investors regarding a shift in the Fed’s policy.  However, we do not anticipate the Fed will make a major change until next year. They will remain vigilant by monitoring the current economic situation, and they are prepared to adjust monetary policy accordingly.  We are also concerned about the sluggish recovery in global growth and the negative impact it will have on domestic improvement.  We are hopeful that global monetary policy leaders will make sound decisions to boost global momentum, though the final outcome has yet to be decided.  Geopolitical risks are always the wild card to the economy and financial markets.  Whether the risk is the recent Ebola outbreaks, the protests over democracy in Hong Kong, or military conflicts around the world, it is almost impossible to quantify the impact these events will have on asset prices and the durability of the domestic and global economic expansion.

 

Individual asset classes can move from the best to the worst performer in the blink of an eye, but a diversified asset allocation strategy with exposure to multiple asset classes may help mitigate the highs and lows experienced in the financial market.  The table below represents the annual returns of various asset classes and that of a diversified portfolio.[2]  In times when one asset class is dominate or has a long stretch of positive returns, it is easy to forget that historical data proves it is impossible to predict the winners for any given year.  Since 1999, REITS have outperformed other asset classes eight times.  An investor who was 100% invested in REITS during this time period benefited from a long period of positive returns, but they also missed out on superior returns of other asset classes like domestic large cap stocks (S&P 500), domestic small cap stocks (Russell 2000), and international stocks (MSCI EAFE). Diversifying your portfolio across multiple asset classes makes you less dependent on the performance of any single asset class.

 

Asset Class Annual Returns - 1999 through 3rd Quarter 2014

 

Date

Three-Month U.S. T-Bill Index

U.S. Intermediate Treasury Bond Index

S&P 500 Index

Russell 2000 Index

MSCI EAFE Index

(net div.)

Dow Jones US Select REIT Index

Diversified Portfolio

9/30/2014

0.03%

1.59%

8.34%

4.41%

-1.38%

14.69%

3.84%

2013

0.07%

-1.34%

32.39%

38.82%

22.78%

1.22%

14.81%

2012

0.11%

1.71%

16.00%

16.35%

17.32%

17.12%

10.45%

2011

0.10%

6.57%

2.11%

-4.18%

-12.14%

9.37%

2.53%

2010

0.13%

5.29%

15.06%

26.86%

7.75%

28.07%

12.74%

2009

0.21%

-1.41%

26.46%

27.17%

31.78%

28.46%

17.42%

2008

2.06%

11.35%

-37.00%

-33.79%

-43.38%

-39.20%

-20.52%

2007

5.00%

8.83%

5.49%

-1.56%

11.17%

-17.56%

3.95%

2006

4.85%

3.51%

15.80%

18.37%

26.34%

35.97%

14.17%

2005

3.07%

1.56%

4.91%

4.55%

13.54%

13.82%

5.52%

2004

1.33%

2.02%

10.88%

18.32%

20.25%

33.16%

11.09%

2003

1.16%

2.10%

28.69%

47.25%

38.59%

36.18%

21.05%

2002

1.80%

9.29%

-22.10%

-20.48%

-15.94%

3.58%

-6.99%

2001

4.44%

8.16%

-11.89%

2.49%

-21.44%

12.35%

-0.93%

2000

6.19%

10.25%

-9.10%

-3.03%

-14.17%

31.04%

1.89%

1999

4.83%

0.40%

21.04%

21.26%

26.96%

-2.58%

11.54%

 

By combining asset classes that behave differently when held during changing economic or market conditions, you can help insulate your portfolio from major downswings.  Look at the returns of the diversified portfolio on the previous page as an example.  The diversified portfolio uses offensive assets (stocks), as well as, defensive assets (cash and bonds) to smooth out the volatile swings of individual asset classes.  In general terms, it is unlikely that a diversified portfolio will ever lead the pack, but conversely the opposite may also be true.  In any given year, it is unlikely that a diversified portfolio will ever be a worst performer.  Simply put, the table helps to reinforce our belief that a diversified asset allocation strategy is a great method to manage portfolio risk while endeavoring to maximize portfolio returns.

 

As I have often stated, our investment philosophy remains based on the fundamentals.  We believe the successful long-term investor is patient, weathers market swings, and adheres to a disciplined investment process. We believe that it is time---not timing---that matters most.  The day-to-day price volatility of the stock market is unavoidable and can be deeply influenced by domestic and international variables.  Investors need to manage their expectations of the stock market accordingly.  In other words: Don’t use your emotions to make investment decisions; separate your money from your moods.

 

In closing, I want to thank you for the opportunity of working with you and for your continued confidence and trust.  Please contact me if you have any questions. 

 

With kindest personal regards, I am

 

Very truly yours,

 

WILLIAM HOWARD & CO. FINANCIAL ADVISORS, INC.



[1] Source: Federal Reserve System. Minutes of the Federal Open Market Committee. 16-17 September 2014. http://www.federalreserve.gov/monetarypolicy/fomcminutes20140917.htm

[2] Data provided by Dimensional Fund Advisors.  Diversified Portfolio composition: Cash 10%, U.S. Bonds 30%, U.S. Large Co. Stocks 30%, U.S. Small Co. Stocks 10%, International Stocks 10%, and Real Estate Securities 10%.  Rebalanced quarterly.

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