October 22, 2014
Dear Clients and Friends:
Bill Gross and Pimco
Elvis has left the building! Many of you will remember this phrase used to alert attendees of Elvis’ concerts that he had left the premises and that there would be no further encores. We thought of this expression when being informed that Bill Gross, a/k/a the Bond King, had resigned from Pimco. While the Elvis phrase meant that there would be no more encores, Bill Gross will attempt one with the Janus Capital Group.
We have been Pimco investors for a number of years, drawn initially to their flagship fund, Pimco Total Return, heretofore run by Mr. Gross. The fund has a history, at least until recently, of providing higher returns per unit of risk taken, a combination considered the gold standard in the investment world. At its peak in April of 2013, the fund had $293 billion in assets. As of October 8, 2014, that had dropped to $222 billion.
Commentators have pointed to the size of the fund as a leading cause of recent underperformance. However, the size of an actively traded fund is less of a factor in the bond management universe. The size of the U.S. bond market is estimated at $38 trillion (source:http://www.sifma.org/research/statistics.aspx). By comparison, the U.S. stock market is a little more than half that size. Superior performance from a bond fund is a function of weighing certain bond fund sectors (treasuries, corporate bonds, mortgages, etc.) more heavily than others and the timing of those calls. The use of synthetic securities (derivatives) also allows managers of large funds to maneuver their allocations without influencing market prices or tipping off their competition.
Bill Gross has been known for his adept moves. However, recent bets on the direction of U.S. Treasury yields have not panned out. While his returns were positive, they were below industry benchmarks and concerns arose as to whether he had lost his golden touch. The fact that he has achieved celebrity status added to public scrutiny. In addition, the U.S. Securities and Exchange Commission announced that they were looking into the security pricing policy of the much smaller Total Return Exchange Traded Fund (ETF) managed by Mr. Gross.
The remaining Pimco team is very experienced and deep. We would not be surprised if they deliver very good results in the years ahead. The research staff and resources at their disposal dwarf any competitor. We also recognize that managers are dealing with imperfect information and that, ultimately, allocations are made using judgment. This is why diversification is important and why we continue to use include funds like Doubleline Core Fixed Income and Fidelity Intermediate Municipal Income as part of our core fixed income holdings. The bottom line is that we are aware of the situation and are carefully weighing our alternatives.
The market is a very complex system with many inputs, including investor behavior that contributes to a range of market movements from mild to chaotic. It is comical to hear financial pundits explaining every single market move, after the fact of course. Also, it was amazing to see the headline changes and predictions these last few weeks once the market started to stumble. Investors were encouraged to get out now. The next day they were directed to buy the dip. Some pundits were sure we are at the beginning stages of a major correction. Others felt just as strongly that this bull market still has legs. It is as if these commentators actually think they can give the green light or red light on when to invest in stocks from one week or one month to the next, while providing virtually no credible evidence for their reasoning. It is more like poor comedy than news. A disheartening thought considering the role investment returns play in helping to achieve future financial security.
The Federal Reserve (Fed) and international central banks have played a vital role in attempting to suppress downside volatility. It is either through Fed action or Fed talking points that they manage to convince investors that "they have your back". The S&P 500 has been in an upward trajectory since early 2009, with small bouts of negative returns mostly around the Fiscal Cliff and Debt Ceiling debates. Most notable has been the last three years, where volatility has been at ridiculously low levels. The VIX Volatility Index has been well below its historical average of almost 20. See the chart below:
History has shown that volatility tends to mean revert, meaning, it trends back to the long-term average over time. Periods of tranquility are invariably followed by bouts of extreme market gyrations. The chart shows how the tranquil period from 2005-2007 was followed by the much more volatile period of 2008-2009. We have no reason to believe that the market will behave differently in the future, and the beginning of this quarter may be the first sign of this. Investors should be prepared for a much bumpier ride than what has been experienced over the last few years. When or why volatility rises or declines is anyone’s guess. The catalyst is always to be determined.
An investment’s calibrated expected return is more important than its long-term historical average in predicting future returns. For example, the current 10-year Treasury bond’s 2.15% yield is significantly lower than its long-term average of 6.5%. Expecting a bond portfolio to achieve returns over the next several years close to long-term would be unreasonable. Expecting a return of 1% over Treasuries by taking on some credit risk would be more prudent.
Projecting stock returns is much more difficult than projecting bond returns, due to the inability to predict investor behaviors. However, current P/E ratios and profit margins suggest modest expected returns for U.S. stocks. The average Cyclically Adjusted Price-Earnings (CAPE) ratio for U.S. stocks is historically around 16. In addition, corporate profit margins are currently about double their historical average.
On the bright side, international stocks, especially those in the Euro bloc, are trading at valuations that are compelling. Below is a sample of CAPE Ratios, a/k/a Shiller P/E, for 8 different countries and their expected 10-year real returns (Source: Research Affiliates):
It is important to remember that a fall in the stock market pushes the expected future return higher. Client portfolios are designed to weather these drops, which gives us the ability to increase allocation to stocks if expected returns increase.
Focusing on market movements and the ongoing financial media circus can cause investors to lose focus on the basic components of risk and return for fixed income and equity markets. Some examples will enable us to illustrate these important concepts.
An investor buys a $5,000 non-breakable CD paying 3% per year for 10 years. He also invests $5,000 in a 10-year Coca-Cola bond paying 3% per year. The very next day, interest rates go up and a new 10-yr CD or Coke bond is offered at 4% annualized. In the investor’s account, the 3% Coke bond now has a value of $4,594. It has just experienced an 8.83% drop! The CD at the local bank still shows $5,000 on the monthly statement.
However, at the end of 10 years, both investments have the same exact return. Why? The bond is a tradable investment that adjusts in price based on the prevailing market rates. It does not change the actual expected return (3%) in any way. It does mean, however, that now an investor has a choice in how to receive the prevailing 4% annualized return. The investor can either: 1) acquire an old bond, adjusted in price or 2) buy a new bond paying a 4% coupon rate. The exact opposite occurs when interest rates decline. In both cases the gain or loss in the market value of the bond is temporary and amortizes down over time to the par value, which is $5,000 in this example.
Note: The longer the duration of the bond (or any asset for that matter), the greater the movement in the price with respect to changes in interest rate (i.e. a 20-year bond in the above example, with all the same other facts, would have declined 15.73%).
While a bond will return its face value at the end of the period, stocks carry no such promise. Also, there is no "end of period" which means that the durationof stocks factors in only the income stream they produce. This results in a duration that is much longer than fixed income assets. Currently it measures around 50 years. When the prospective, or "expected", rate of return for stocks increases by 1% (similar to the increase in interest rates for bonds), the same pricing mechanism is in play, but with an asset with a much longer duration. As stated above, the longer the duration, the greater the sensitivity to changes in rate.
Jon Hussman provides a nice analogy as an example that explains the impact of duration:
"First, hold your arm out sideways from your body, and imagine that you're holding a pencil that's about 10 miles long. Now raise and lower your arm a little. If there was a tiny little guy sitting right on your shoulder, or just a few inches out onto your arm, he would ride up and down a bit, but he would be fairly stable. If the little guy was sitting on your hand as you move your arm up and down, his ride would be a bit more exciting. Of course, if the poor little fella was sitting at the end of that pencil, he'd be screaming and holding on for dear life at the slightest move in your arm."
That's duration. It measures that "distance" more accurately than the stated maturity of a security, and also measures the sensitivity of the security price to changes in its yield.
When interest rates change, securities with short durations (such as Treasury bills) don't fluctuate much in price. But securities with long durations (such as 30-year zero coupon bonds) can swing wildly."
We continue to be in an environment of ultra low interest rates and high U.S. equity prices. This translates into modest expected returns for the foreseeable future. This does not mean that stocks and bonds can not rally. However, any rally in bonds is only stealing from future returns. Any rally in stocks, without underlying growth to support it, reduces future returns.
Increasing bond yields would cause portfolio declines in the near term, but that is the only possible way that bond returns increase in the future. Absent a pickup in growth andsustained record profit margins, which we deem improbable, stock prices will need to fall if we are to experience healthier returns going forward. Our goal is for clients to achieve decent long-term returns. Downward adjustments and subsequent rebalancing between assets classes are, at times, a necessary evil that allows us to achieve this result.
Property & Casualty Insurance Reviews
The following liability awareness issues were communicated to us during a recent review of auto, home and umbrella policies by insurance agents:
- · Parent owns a vehicle being driven by an adult child not living with the parent.
- · Adult child owns a vehicle insured on the parent’s policy.
- · Parent owns a vehicle listed on the adult child’s policy.
Clients should make sure that they are not unnecessarily putting assets at risk by accommodating other family members in these situations. If you are the individual with assets to protect, contact your agent and discuss remedies. These may include:
- - Transferring ownership of a vehicle used by an adult child not living with you to that child and having the child secure insurance coverage.
- · Securing separate coverage for a parent living with you but still driving a car he or she owns.
Year-End Tax Planning
Our advisors will soon be engaged in year-end tax planning. Proper planning requires the review of your filed 2013 returns, and projecting your tax liabilities for 2014 and 2015. As part of this review, we will be processing Required Minimum Distributions (RMDs) from IRAs of clients who need to meet that requirement. Our review will include recommendations of federal and state income tax withholding from these distributions.
If you are employed for any period in 2014, or receive a pension, please provide us with your most recent paystub or pension statement. We cannot overemphasize the importance of responding to our requests for information as quickly as possible as the year-end approaches. Providing you with the best possible service and recommendations requires a high level of timely cooperation.
Fidelity Charitable Gift Fund
Using a charitable gift fund allows you to make a higher than normal deductible gift in one tax year and spread out the actual disbursements to charities in future years. This allows you to receive a higher tax break than making the same total contribution to charities spread out over years subject to a lower level of taxation.
This benefit is often combined with a contribution of one or more low tax basis securities to the gift fund, allowing for an immediate tax-free sale to diversify or preserve principal.
Clients wishing to set up a Fidelity Charitable Gift Fund account should contact us for assistance or to answer any questions you may have on how these accounts work. The decision to actually fund the account can be made in the tax year of choice.
Donations in Lieu of Holiday Gifts
It is a tradition at Schiavi + Dattani to deliver gift baskets to our clients during the holiday season. Clients do have the option of donating the value of their gift to charity.
Because of administrative constraints, we limit the charities eligible to participate in this program. Clients who would like to direct their gift should contact Kate Madden at our office before Friday, November 14th.
She can be reached at 302-994-4444 or via email at firstname.lastname@example.org
This following is a list of this year’s charities, emphasizing children’s health issues:
The Andrew McDonough B+ Foundation
– A locally based charity providing financial and emotional support to families of children with cancer. It also funds childhood cancer research and awareness programs. Only 3% of the National Cancer Institute’s annual budget funds childhood cancer research. Learn more at: www.bepositive.org
Children’s Health Fund – Co-founded in 1987 by singer and songwriter Paul Simon, this charity is committed to providing healthcare to the nation’s most medically underserved children. The charity receives an "A" rating by the American Institute of Philanthropy. Learn more at www.childrenshealthfund.org
Save the Children–Invests in children in the U.S. and 199 other countries with programs in child protection, education, emergency response, and health and nutrition. The charity receives an "A+" rating by the American Institute of Philanthropy. Learn more at: www.savethechildren.org.
We encourage everyone to reflect on the needs of others as we approach the Thanksgiving season. We continue to work daily to earn your trust and confidence.
Vincent A. Schiavi, CFP®, CPA/ PFS Ravi P. Dattani, CFP®, CPA
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