"Kee" Points with Jim Kee, Ph.D.

Global economies: Second quarter US GDP was revised upwards slightly by the Bureau of Economic Analysis, from 3.7% to 3.9%. At the same time, the Atlanta Fed’s GDPNow estimate for the third quarter edged down, from 1.5% on September 17 to 1.4% last Thursday. I think that’s a little more indicative of where we are in the US right now, though perhaps a bit too pessimistic (and more consistent with recent data like existing home sales and durable goods orders - both down in August). Looking abroad, China concerns continue as Chinese data (most recently the manufacturing PMI) indicate continued slowing. China’s slowdown has been felt throughout the emerging markets. Europe has thus far been pretty resilient to all of this, helped in part by the positive shock of a declining euro over the past year, and also from pent up demand that has been building since the onset of the European debt crisis. Overall, the picture is one of positive but moderate growth in the developed world, and growth in emerging markets that is well below expectations of even a few months ago. This has caused the majority of research houses and official agencies to further revise downward their growth estimates for global GDP to the 2%-3% range.

 

US Stocks remain in correction range, being down about 10% from their August peaks (down about 4.5% for the year). This seems to fit economist Jeremy Siegel’s observation that September is easily the worst month for stocks (going back 100 years in the data), and that the September sell-offs appear to be moving into late August, perhaps in anticipation of September. But fourth quarter rebounds are also increasingly common. I can see uncertainty over Fed rate hikes extending market volatility a bit, since the Fed didn’t move in September. Corrections are not really environments to fear, particularly when domestic and global concerns (growth, Fed, budget showdowns) are widely shared. The opposite case - when it all appears to be smooth sailing ahead - tends to be the hardest on equity investors in subsequent periods. To use a striking example, Siegel noted that the Nasdaq, if it we’re trading at the same price-to-earnings (P/E) ratio that it was at its March 2000 peak, would be at 100,000 today rather than today’s 4686(!). Recall that back in March of 2000 it was believed that the business cycle was dead due to things like just-in-time inventory management and of expertise on the part of the Federal Reserve to “manage” the cycle (e.g. the Great Moderation). And it was also believed that the threat of war was over because of the collapse of communism, hence the “peace dividend” of lower defense spending. Now that was an optimistic environment! Finally, Japanese stocks are down over 15% since August, but are still positive for the year. European stocks are still slightly ahead of the US but also negative for the year, and emerging markets – which peaked in 2011 (they were higher still in 2007) - are well into bear-market territory.

 

As for bonds, a headline in this weekend’s Barron’s is worthy of notice: “U.S. Junk Bond Rout Pushes Yields Past 8% as Treasuries Gain.” The “rout” in junk bonds highlights an important truth, namely, that in bond markets, higher yields come with higher risk. At STMM we feel that most people should put the majority of their wealth in a well-diversified portfolio of high quality individual stocks and bonds. Given the current environment, it is worth briefly repeating some of the key aspects of bond investing, and of the importance of holding individual bonds rather than bond funds or other pooled investment vehicles:

 

Bond funds introduce new risks to bond investors: It is helpful to keep in mind that bond investors are generally subject to two types of risk, interest rate risk and credit or default risk. Owning a portfolio of individual bonds rather than bond funds is the best way to manage or control exposure to both. Interest rate risk occurs when interest rates in the economy rise. Rising interest rates lower the price of existing bonds, because buyers of existing bonds can only earn the now higher yields by buying existing bonds at lower prices. But if you own individual bonds (rather than bond funds) you have less concern about whether or not their prices fall. That is because you can hold them to maturity and get paid back the full face value. That is, you control when bonds are sold, not other investors as occurs in bond funds or other “pooled” investment vehicles. When investors in these funds pull their money out, the fund has to sell, meaning you have to sell. The second kind of risk to bond investors is default risk, or the risk that the borrower (bond issuer) won’t be able to pay back the lender (bond buyer). In their search for higher yields, many bond funds have invested in stocks, or derivatives, or riskier securities like emerging market debt. Many of these securities carry a much higher risk of default. And some bond funds have begun investing in securities (like stocks) that are not bonds at all , which introduces a new kind of risk to investors (in addition to interest rate and default risk). Other risks in the current environment occur in the tax-exempt market. Municipal bond funds have owned bonds issued by problem-plagued municipalities, like Puerto Rico, Chicago, and Detroit. These funds are particularly worth a word of caution today, for while the pension-fund picture is improving for most states (Barron’s), it has grown much worse for others like Connecticut, Kentucky, New Jersey, and Alaska. Owning a portfolio of individual bonds is the easiest way to know and monitor exactly which municipal bonds you own and don’t own.

 

Quality bonds diversify a stock portfolio, risky bonds do not! The ability to manage interest rate risk and credit risk is crucial if bonds are to perform one of their most important jobs for your portfolio, which is to act as an offsetting hedge to your stock or equity exposure in times of uncertainty. Good, high quality individual bonds are a natural, low-cost and transparent hedge to equity risk, while low quality (i.e. “high yield”) often opaque bond funds are not. This was pointed out last week in an article on Chicago bond manager, Nuveen Investment’s High Yield Municipal Bond fund, which dropped -40% in 2008 (Bloomberg). High yield bond funds did horribly during 2007-09, the stock market capitulation, with some like John Hancock High Yield (sounds solid, right?) losing -58.8%, worse than stocks! (or Oppenheimer Champion Income fund, down -82.9%). But solid, high quality bonds enjoyed positive returns for the same period. For example, the Barclays Capital Aggregate Bond Index gained 7.2% during the 2007-09 crash, and the Barclays Capital Municipal Bond index was up 2.4% for the same period. It is extremely important for investors that they not invest in bonds that behave like stocks during risky times!