mattgarrott

By: Matt Garrott

Returns were positive across almost all asset classes in the second quarter. The Barclays Aggregate Bond Index was up 2.0%. Municipal bonds popped up 2.6% and TIPS rose 3.8%. Foreign bonds were up 2.8%. US Large Cap stocks as measured by the S&P 500 returned 5.2% while Small and Mid Caps gained 3.7%. International Developed Markets stocks were up 4.1% and Emerging Markets up 6.6%. Real Estate continued to rally, up 7.2%. Commodities ended the quarter flat.

The stock market is on pace for another outstanding year, contrary to the narrative that fear-mongering salespeople have been peddling. It can be frustrating not to fiddle with a portfolio, even when the market has done well. There are always fad investment strategies that sound like a great way to eke out an extra couple of percentage points of return, but in reality only benefit the money manager. As these sales pitches seem to have increased recently, it feels like a good time to assess allocations to stocks and bonds to see if we should abandon these asset classes as so many seem to suggest.

On a scale of despair to euphoria, investors are straddling the line between skepticism and hope regarding stocks. It has taken five years from the market’s bottom for stocks to get back to a fair valuation (the S&P 500’s P/E is 15.6 – the 25 year average is 15.5). Being fairly valued does not signal a market top. These are not the high flying days of the tech bubble. Corporate management is still conservative and about 30% of the S&P 500’s corporate assets are in cash. Early in the recovery, corporations spent money on dividends and buybacks. Lately we’ve seen more spending on mergers and acquisitions. Innovations in software, biotechnology, and energy are rampant. The American energy renaissance has helped dampen the effects of Middle Eastern turmoil on the markets.

With the 10-year US Treasury Bond yield at around 2.5%, rates are running out of room to fall. This sounds familiar as investors have been sold on the fear of a rising rate environment for three or four years now. Running out of room is not the same as having no room, however. Japan (0.55% 10-year) and Germany (1.26% 10-year) both have lower yielding government debt. This isn’t a huge surprise as these are two traditionally strong countries. What is surprising is that Spanish debt yields 2.7%, effectively allowing Spain to borrow on the same terms as Great Britain! Spanish debt previously yielded 7% until the European Central Bank made loud noises about doing “whatever it takes” to ensure the survival of the Euro. On a relative basis, the US 10-year is looking cheaper and cheaper. Despite (or maybe because of?) central bank interference, bond investors are euphoric. Artificially low rates are creating massive demand for yield. Investors are diving down the credit ladder head-first, indiscriminately buying high yield anything. Bank loan funds are seeing massive inflows as they are sold by brokers touting their ability to adjust their yields as rates rise. Investors will be disappointed to find that many of these adjustments will never happen as they are only triggered at unlikely levels. The influence of the world’s central banks means that this frantic buying may continue for quite some time. When the music eventually stops, the folks holding high yield are not going to be happy.

Should investors sell out of stocks and bonds and plow their money into CNBC’s strategy of the month (or day, or hour)? No. As the growth in the wake of the financial crisis continues in slow motion, investors must take care not to over-manage their portfolios. The more drawn-out the bull market becomes, the more urgent the shouting of market-timers becomes. Sticking with a financial plan can be boring, but isn’t that the point? A plan eliminates the anxiety caused by media noise, allowing investors to focus on things that are truly important to them, rather than the latest economic data point.