Bear Market Anniversary Reflections

March 9th marked the 9 year anniversary of the most recent bear market bottom. It passed quietly with no bands playing and no flags flying. For those who endured the decline, it was a stressful experience that tested the mettle of all of us as investors. The market peaked in October 2007, and then the S & P 500 index of large-company US stocks fell 37% in 2008. Stocks continued to fall in early 2009, until the market finally bottomed on March 9th.  Overall, there was about a 57% decline in the S & P 500 from peak to trough, the magnitude of which no one had seen since the Great Depression. Although the length of the decline was in line with the post-World War II average for a bear market at 17 months, it seemed like it would never end. After hitting the bottom on March 9, 2009, the market recovered sharply and closed up 26.5% for the year. It is interesting to note that despite these declines, the calendar years 2007 and 2009 were both positive for stocks. All declines, while distressing at the time, have proven temporary.

2017 marked the 9th positive year in a row for stocks. While we remain optimistic about the economy, we recognize that eventually there will be another negative year or years. There’s just no way to predict exactly when these will occur. Fortunately, all the major declines in modern history have been short-lived, typically lasting 2-3 years. In the past 92 years, 1929-32 was the only consecutive 4 year down period for stocks. 1973-74 was a 2 year decline, and 2000-02 was a 3 year decline.

If you don’t know when the declines are going to come, what can an investor do to maximize their chances of success?

Make sure you have an appropriate asset allocation (mix of stocks, bonds and cash) that suits your individual risk tolerance and spending needs. You should keep enough cash to provide for emergencies (we typically recommend 3-12 months of after-tax living expenses) and enough fixed income to serve a source of spending when stock prices are lower. While bonds are not particularly attractive right now with interest rates likely to rise from here, you will be glad you have them to help weather the periodic declines that historically are short-lived.

-Avoid making dramatic changes to your portfolio based on news headlines or the mood of the day.  The sudden “I’ve got a feeling” moves in to or out of the market, with a large portion of your portfolio are what can really hurt investors.

Focus on portfolio income. Dividend income from the stocks in your portfolio should be higher each year since more companies will increase their dividends than cut them. Many S & P 500 companies have histories of consecutive dividend increases of 25 years or more, with some over 60 years.

Understand how much you are spending, including what is discretionary and what is not.  The household spending level is the hardest question for most people to answer as we are updating their financial plans. If you are a Parsec client, take advantage of our eMoney portal to get a better idea of your spending by linking your credit cards and bank accounts. Access to the eMoney portal is included at no additional cost to Parsec clients.

Once you have a good grasp of your expenses, periodically monitor your spending level in relation to your portfolio income and investment assets, and adjust if needed.

Historically, the stock market has many more up years than down years. The key is having an appropriate asset allocation, not making dramatic changes to your portfolio based on the mood of the day, and periodically rebalancing to your target mix (which forces the discipline to buy low and sell high).

 

Bill Hansen, CFA

President and Chief Investment Officer

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What a Rising Rate Environment Could Mean for Bond Funds

After the yield on the 10-year U.S. Treasury Bond – a widely used economic bell weather – bottomed in July 2016, interest rates have risen substantially through March of this year.  The recent upward pressure on yields has pushed bond prices lower.  Strong economic growth, ongoing interest rate hikes from the Federal Reserve, and recent political developments could mean higher yields ahead.  Given the current environment, we’d like to take a closer look at bonds and bond funds.  We’ll examine how they work, a key risk metric to consider, and how these investments might perform if interest rates continue to rise.

Bonds are a type of fixed income investment given the regular cash flows a bondholder receives.  Similar to your home mortgage but with the roles reversed, investors who own bonds are loaning money to an entity (usually a corporation or a government) in exchange for a variable or fixed interest rate over a specified period of time.  This interest rate is known as the bond coupon and it varies based on the credit worthiness of the entity and the length of the payback period, among other factors.

While a bond’s coupon rate, or its stated yield at issuance, remains fixed for the life of the bond its price or value on the open market will vary based on prevailing interest rates.  When interest rates rise, bond prices fall, and when interest rates fall, bond prices rise.

How sensitive a bond’s price is to a change in interest rates is measured by a term called duration.  Specifically, duration is a measure of interest rate risk.  It indicates how much a bond’s principal value will rise or fall due to a change in interest rates.  Measured in years, a bond or bond fund with a higher duration will be more sensitive to changes in interest rates than a lower duration bond or bond fund.  As a result, a portfolio of bonds with a higher duration will fall more in price as interest rates rise than a portfolio with a lower duration, all else being equal.  Fortunately, bond mutual funds or ETFs report their portfolio duration and investors can use this metric to gauge short-term risk.

I say short-term risk because while a jump in interest rates – as we’ve seen recently – will weigh on a bond fund’s near-term performance, the higher current income that comes as a result of an increase in interest rates will often offset much of the decline in a bond fund’s value over the long-term.  This is one benefit of owning multiple bonds or a fixed income fund versus an individual bond.  Because a portfolio of bonds or a bond fund doesn’t have a single maturity date (instead it contains many bonds with different maturity dates), it can provide more income flexibility.  For example, in a rising rate environment, as some bonds in the portfolio mature, the manager can reinvest proceeds from those securities into new bonds that now have higher yields.  In turn, this pushes the portfolio’s yield up and helps to offset price declines.  In particular, bond funds can offer significant diversification benefits given their exposure to many individual bonds with different durations and credit profiles often for a low fee.

While a bond fund’s duration will indicate how much it declines (or rises) in price when interest rates rise (or fall) over a given period, it also indicates how much of a boost it will get from new, higher yields.  Bond funds with higher durations – which are more sensitive to interest rates – typically offer higher current yields to compensate for their higher risk profiles.  So while bond portfolios with higher durations will experience sharper price declines when interest rates rise, they’re also more likely to benefit from higher current income over the long-term.  At the same time, bond funds with shorter duration – which are less sensitive to interest rate changes – won’t benefit as much from higher current income associated with rising interest rates, but they won’t fall in price as much either.

The point is that bond duration is a useful risk metric.  When a fund has a higher duration it tells us that its price will fall more dramatically when interest rates rise as compared to a lower duration fund, but it should benefit more from higher current income tied to higher yields.  The key, however, is your investment time-horizon.  As an investor, you’ll be able to benefit from the higher current income of a longer duration bond fund only if your time-horizon exceeds the fund’s duration.  When it does, higher income over the long-term should offset near-term price declines.

This dynamic – of higher income offsetting falling bond prices – is related to the nature of bonds and is nicely illustrated by the Bloomberg Barclays U.S. Aggregate Bond Index.  According to Charles Schwab, since 1976 over 90% of this index’s total return has come from income payments rather than price changes.

While most investors should fair well with a bond fund that is aligned with their investment horizon, diversification is another important consideration.  As stocks have historically delivered the strongest long-term returns and have outpaced inflation since the early 1900’s, bond investments are best used when there is a specific income need.  When this is the case, having a mix of shorter and longer-duration bond funds can help an investor take advantage of a changing interest rate environment and mitigate sharp price swings.  In today’s environment, owning bond funds with varying durations – in proportion to one’s income needs, investment time horizons, and risk tolerance – an investor should be better able to take advantage of rising interest rates.  For example, let’s take a client with 20% of his bond holdings in a short duration fund, 20% in an intermediate duration bond fund, and 60% in a long duration bond fund.  If interest rates were to rise sharply, the lower duration fund would see a small if negligible decline in value. In some cases, it may make sense for the investor to sell some of those shorter duration securities and use the proceeds to add to their long duration bond fund, which would now have a higher current yield.

In addition to duration and price sensitivity, Parsec’s Research Committee considers many other factors when constructing a client’s fixed income portfolio.  We also look at where we are in the credit cycle, the underlying quality of each bond asset category, valuation levels, and inflation sensitivity, among others.  Although thorough and well thought out research is critical to meeting your financial goals, staying invested for the long-term is even more important.  When appropriate, doing so with a fixed income portfolio can help you better weather significant price swings and ultimately benefit from current income.

Thank you,

The Parsec Team

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Why Trying to Time the Market is a Losing Game

The U.S. stock market has returned 282% since bottoming in March 2009, following the Financial Crisis.  Since that time, the S&P 500 Index has delivered positive returns in seven out of the last eight years and appears poised to produce another gain in 2017.  While it’s true that valuation levels are above long-term historical averages, in this email we’ll explore why trying to time the market is a losing game.

As a client you may be concerned that higher stock valuation levels coupled with a long-running bull market could mean an imminent pullback.  If so, you’re not alone.  Many investors have noted that it’s been a while since we’ve had a major stock market correction (defined as a drop of 10% or more).  This makes sense given that historically, the stock market has averaged three pullbacks of about 5% per year, with one of those corrections typically turning into a 10% or greater decline.  While it has been twenty-two months since our last market correction, we’ve seen longer.  Since 1990, we’ve experienced three periods lasting longer than twenty-two months over which markets did not experience a 10% or greater pullback.  So although we’re not in uncharted territory, the historical record suggests we could be closer to a market decline than not.

Given the above facts, clients often ask why we don’t sell stocks and raise cash in order to avoid the next market correction.  It’s a fair question, but when examined more closely we find that it’s a very difficult strategy to implement successfully.

Research has shown that trying to time the market is a losing game.  One reason is that an investor has to accurately predict both when to get out of the market and when to get back in.  While it’s difficult enough to time an exit right, the odds of then correctly calling a market bottom are even lower.  Part of this relates to the nature of market declines.  Looking back to 1945, the average stock market correction has lasted just fourteen weeks.  This suggests that investors who correctly sell their stocks to cash may be sitting on the sidelines when equities surge higher, often without warning.  While moving into cash may avoid some near-term losses, it could come at the higher cost of not participating in significant market upside.

Another reason to avoid market timing relates to the nature of market returns.  History shows that since 1926, U.S. large cap stocks have delivered positive returns slightly more than two thirds of the time.  As a result, you’re much more likely to realize higher long-term gains by remaining fully invested in stocks and weathering some of the market’s admittedly unpleasant downturns.

At Parsec, instead of market timing, we recommend investors stay invested throughout market cycles.  While this can be difficult at times, investing in a well-diversified portfolio has been shown to help mitigate market volatility and provide a slightly smoother ride during market downturns.  This is because portfolios that incorporate a thoughtful mix of asset classes with different correlations can provide the same level of return for a lower level of risk than a concentrated or undiversified portfolio.  It also ensures that investors participate in market gains, which often materialize unexpectedly.

In addition to constructing well-diversified portfolios, we believe in setting and maintaining an appropriate asset allocation based on your financial objectives and risk tolerance.  We then rebalance your portfolio to its target weights on a regular basis.  This increases the odds that you sell high and buy low.

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Value Stocks May be Poised to Outperform

Since Parsec’s founding in 1980, we’ve touted the benefits of long-only equity investing.  This includes owning individual stocks, mutual funds, and exchange traded funds (ETFs).  We’ve also maintained the same investment style over the last thirty-seven years.  Regarding funds, Parsec’s investment policy committee (IPC) focuses on low fees, higher-quality holdings, and managers with long track records of outperformance.  When researching individual stocks, we take a value approach, favoring higher-quality companies that trade at a discount to history or peers.

While history shows that value stocks have outperformed growth stocks over most market periods, in recent years growth stocks have delivered higher returns.  In this email we’ll discuss what we mean by value versus growth investing and why we believe value stocks are poised to outperform going forward.

Different stock investors define “value investing” differently.  However, most agree on a few basic principles.  In general, value investors prefer stocks that trade at discounts to their intrinsic values.  Often this happens when a stock’s valuation falls below its long-term historical average or that of its peers.  Another tenet of value investing is margin of safety.  This means selecting stocks that can deliver healthy total returns even if current growth assumptions fall short of expectations.  While we consider ourselves value investors, we will add select growth stocks to the Parsec buy list when expectations look reasonable and a company has a competitive advantage.  In other words, when we think a stock has a reasonable margin of safety.

In addition to a value-based stock selection approach, Parsec’s investment philosophy also has a quality bias.  This means we prefer companies with strong cash flows, consistent earnings growth, a long history of dividends, and above average returns on invested capital.  We also favor companies with strong balance sheets that can withstand different market environments and even gain market share during difficult economic periods.

Looking back over the market’s history, value stocks have outperformed growth stocks by an average of 4.4% annually from 1926 to 2016 (Bank of America/Merrill Lynch).  More recently from 1990 to 2015, value stocks outperformed growth stocks by just 0.43% annually.  The spread has since reversed and in the last ten years value stocks have lagged growth stocks by 3% annually through the second quarter of 2017*.

The shift in leadership from value to growth stocks coincided with the start and continuation of the Federal Reserve’s massive monetary accommodation programs known collectively as quantitative easing (QE I, II, and III).  Those programs put additional downward pressure on interest rates.  In the face of low or no yields and the slowest economic expansion after a deep recession in over 120 years, investors demonstrated a preference for growth stocks over value stocks.  They were willing to pay up for companies delivering higher growth in a world where growth had become scarce.  Throughout the last ten years value stocks have occasionally outperformed, but usually in tandem with a steepening Treasury yield curve and thus improving growth expectations.

Because asset prices and interest rates are inversely correlated, very low interest rates over the last decade have led to above-average asset valuation levels.  This has been even more pronounced among growth stocks as investors have been willing to pay a premium to own them in a slow growth environment.  As a result, typically higher-priced growth stocks are even more expensive today.

Sticking to our value- and quality-biased investment approach has admittedly been a headwind in recent years.  However, we believe higher-quality stocks trading at a discount are poised to outperform.  Growth stocks currently trading at premium valuation levels will have further to fall in the event of a market downturn.  As well, low interest rates have prompted corporations to take out record debt levels.  As rates begin to rise, higher-quality companies or those with strong balance sheets and robust cash flows will be better able to service their debt levels, even during an economic downturn.  While maintaining our investment approach through the current environment has been challenging, we feel confident that investing in higher-quality companies trading at discounted valuations will reward clients over the long-term.

*References the Russell 3000 Growth Index and the Russell 3000 Value Index

The Parsec Team

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What’s Ahead for Fixed Income?

After more than thirty years of falling interest rates and thus rising bond prices, yields may be moving higher.  While trends are often short-lived, this new trajectory could persist into 2017 and beyond given recent changes in the political landscape as well as a less accommodative Federal Reserve (Fed).  We’ll take a look at what this new monetary and political environment may mean for bonds and how to best-position your fixed income portfolio for the long-term.

A proxy for the bond market, the 10-year Treasury note yield hit an historical low of 1.36% in July 2016 only to jump 100 basis points (or 1%) by the end of November.  The move came as investors responded favorably to the surprise U.S. Presidential and Congressional election results, in anticipation of higher growth levels in the years to come.

Part of the optimism stemmed from the new administration’s promise to cut consumer and corporate taxes and spend on infrastructure projects.  This picture presents a mixed bag for bonds, however.  Increased fiscal spending and lower taxes are positive for economic growth and a healthy economy is generally good for lending and credit activity.  But stronger economic growth would push yields higher and thus bond prices lower.  On the other hand, higher yields would provide investors with higher current income, acting as a partial offset to lower bond prices.  Rising interest rates or yields would also allow investors to reinvest into higher-yielding bonds.

Duration is an important characteristic to consider when reinvesting at higher yields.  A bond’s duration is the length of time it takes an investor to recoup his or her investment.  It also determines how much a bond’s price will fall when yields rise.  Longer duration bonds such as Treasury or corporate bonds with long maturities experience sharper price declines when yields rise.  Likewise, shorter duration bonds are less volatile and will exhibit smaller price declines, all else being equal.  Because we can’t predict the exact direction or speed of interest rate changes, it’s important to have exposure to bonds with a mix of durations.  In this way an investor is able to respond to any given environment.  For example, when yields are rising, an investor can sell her shorter-duration bonds, which are less susceptible to prices changes, and reinvest into longer-duration bonds with higher rates.

Another factor that affects bond prices is inflation.  Inflation expectations have started to heat up in light of low unemployment, wage growth, and expectations for increased government stimulus.  Higher inflation could also put upward pressure on interest rates and thus downward pressure on bond prices.  While inflation can erode the real returns of many bonds, some bonds, such as Treasury Inflation-Protected Securities (TIPS), stand to benefit.  TIPS are indexed to inflation and backed by the U.S. government.  Whenever inflation rises, the principal amount of TIPS gets adjusted higher.  This in turn leads to a higher interest payment because a TIPS coupon is calculated based on the principal amount.

Finally, the Federal Reserve’s shift away from accommodative monetary policy will have an impact on bond prices.  Although higher interest rates from the Fed will likely pressure fixed income prices, overall we view this change favorably.  This is because a return to more normal interest rate levels is critical to the functioning of large institutions like insurance companies and banks, which play a key role in our society.  Likewise, higher interest rates will provide more income to the millions of Baby Boomers starting to retire and would help stabilize struggling pension plans at many companies.

Taken altogether and in light of an uncertain environment, we believe a diversified bond portfolio targeted to meet your specific fixed income needs is the best way to weather this changing yield environment.  In addition to considering your specific income objectives, our Investment Policy Committee meets regularly to assess the current economic, fiscal, and monetary environment.  We adjust our asset allocation targets in order to take advantage of attractive opportunities or reduce exposure to higher-risk (over-valued) areas.  While we may over-weight some areas or under-weight others, in the long-run we continue to believe that a well-diversified portfolio is the best way to weather any market environment.

Thank you,

The Parsec Team

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Scared Money Don’t Make Money

Recently, I heard the above phrase in a rap song by Pitbull.  I was surprised to hear mention of investment risk/reward in a popular song.  He did not go on to discuss European economic instability or currency valuation.  That would have been truly shocking.

The statement provokes thought, though.  People who are willing to take the most risk have the potential for greater reward – and greater loss.  It is easy to have an asset allocation of 100 percent equities in an up market.  Can you keep that allocation when the market is significantly down?  Will you still sleep at night?

On the other hand, holding money in a money market fund earning near-zero interest is also a risky proposition.  You must find some vehicle in which to invest because you cannot afford to earn nothing for your money.  Inflation continues to rise, even when interest rates are not.  The dollar you stash in a mattress will not be worth the same 10 years from now as it is today.

Finding the right allocation is very tricky.  It requires a great deal of evaluation on your part.  What is your current age?  Do you have enough time to recover from a short-term loss?  What are your investment goals for the next 5, 10, 15 years?  When do you want to retire? 

This is just a sample of some of the questions you should ask yourself.  A thoughtful review of your situation with your investment advisor will help the two of you to determine the best asset allocation.  Being brutally honest with yourself and communicating your goals, thoughts, and concerns with your investment advisor will allow you to work as a team.  The two of you will be able to find the right allocation that can help you sleep a little better at night.

Cristy Freeman, AAMS
Senior Operations Associate

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