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Second Quarter 2013 - Pinnacle Investment Management, Inc.

Second Quarter 2013

July 1, 2013 / Quarterly Newsletters

The first-half of 2013 was a tale of two markets.

While the US Stock market had its best first-half since 1999, bonds lost ground as long term interest rates began rising.  Investors with diversified accounts benefited from their stock investment but were penalized for their bond holdings.  Stocks and bonds did markedly better in the first quarter than the second.  Both markets declined in June after Federal Reserve Chairman Bernanke made a seemingly innocuous statement that the economy was recovering and if the domestic and global economy continues to improve the Fed may begin reducing their $85 billion per month purchases of bonds near the end of the year.  He indicated that they may stop further purchases in 2014 or 2015.  More importantly, neither Bernanke nor the Fed has announced plans to raise interest rates.  Investors mis-interpreted the Fed’s statements, creating unnecessary havoc in the markets.

While the Federal Reserve’s statement did not contain any alarming or unexpected information both bond and stock prices declined as investors, fearing interest rates would quickly rise, sold both stocks and bonds.  Long term bonds, non-dollar denominated bonds, and emerging market stocks and bonds were hit particularly hard.  The statement by Chairman Bernanke had unintended and unwarranted consequences in addition to a drop in stock and bond prices.  When investors sold bonds, it resulted in lower bond prices and higher interest rates.  Rising US interest rates caused the US dollar to strengthen, reducing the value of foreign investments when translated to US dollars.  A falling dollar was also responsible for declining prices of commodities and precious metals.

The yield on the ten year US Treasury bond rose from 1.9% to 2.5% during the quarter and the rising rates resulted in low bond returns.  The Barclays Aggregate US Bond Index was slightly negative for the quarter.  Rising rates also increased mortgage rates, although they are still very low by historical standards.

Returns for key indexes (including dividends) were:

First Quarter 2013 Second Quarter 2013 First Half 2013
Dow Jones Industrials 12.0% 2.8% 15.1%
S&P 500 10.4% 3.0% 13.8%
NASDAQ 8.2% 4.1% 12.7%
S&P 400 mid-cap 13.0% 0.6% 13.8%
Russell 2000 small-cap 12.0% 2.7% 15.1%
Total International, excluding US 2.2% -3.5% -1.4%
Dow Jones World Stock 6.3% -1.1% 5.1%
Barclays Aggregate Bond Index 0.1% -2.6% -2.5%

Economic and Market Outlook

There is little evidence that the Fed’s quantitative easing (QE) or Congressional stimulus spending has produced the economic benefits hoped for.  The US economy is growing at a very slow pace – far below that of most economic recoveries.  The only noticeable result is that US government debt has grown and the Fed’s investment in bonds has burgeoned.  Winding these programs down is the prudent thing to do and should benefit the economy.

The Fed’s announcement should not have a long term impact on the markets.  Investors over-reacted which created turmoil but it likely drove some speculators from the market and will help reduce future market turmoil.

The Federal Reserve has held interest rates at historically low levels since 2008 but rates are now poised to rise as the economy improves.  An important question is what will happen to stock and bond returns in a rising interest rate environment.  History can give us guidance.  The Federal Reserve held interest rates low for an extended time in the 1940’s and then began raising them in 1948 and they continued to rise (albeit not in a straight line) until 1981.  When the Fed allowed interest rates to rise investors moved out of bonds and into stocks, causing stocks to advance.  According to Craig Israelsen Ph.D., the annual return on US intermediate term bonds was 3.8% as interest rates rose during the 1950’s 60’s and 70’s.  During the following period of declining interest rates, from 1982 to 2012 bond returns were 8.8% per year, a significant improvement.  In contrast, Dr. Israelsen found US stocks performed about the same over the long term in both a rising and falling interest rate environment.  The S&P 500 returned 11.0% from 1948 to 1981 when rates were rising and 11.1% from 1982 to 2002 when rates were declining – not much difference.  That said, Professor Jeremy Siegel found that stocks did not perform as well in the short term twelve months after the Federal Reserve began raising the “fed funds” interest rates as they did when the Fed lowered rates or held them steady.  This suggests that stocks will become more attractive long term investments compared to bonds but that the stock returns will be lower in the twelve months following a Fed rate hike.  Many economists do not believe that the Fed will increase the federal funds rate before 2015.

Does the prospect of lower returns in the bond market mean that investors should abandon bonds?

The short answer is no, however each investor has unique circumstances which need to be considered.  For investors who have a very large allocation to bonds, this may be a time to re-evaluate the allocation.  While bonds are less attractive investments when rates are rising and may actually lose value if interest rates rise too quickly, no one knows exactly when and how quickly rates will rise.  Bonds are much less volatile than stocks; an important reason for holding bonds is for the stability they provide.  It is important for investors not to invest more in stocks than they are comfortable with since that may result in selling investments after a market drop and be detrimental to their financial health.

Banking risks in China

There is growing concern that Chinese banks are holding and hiding a significant amount of bad debt as a result of their lending to “shadow banks”.  Reportedly, large banks in China, borrow cheaply from the government, then lend to trust companies and smaller banks that in turn make very risky loans, some of which are already in default.  This undisciplined lending has helped fuel the rapid expansion of the Chinese economy.  The underlying risky and bad loans do not show up on the bank’s books so the large banks can still borrow cheaply.  Reportedly this problem is widespread and could lead to bank failures, and result in a banking crisis in China.  This may remind you of the US mortgage crisis or the boom and bust in the Japanese economy twenty years ago caused by overly-lenient lending practices.  This could have serious implications since China is the world’s second largest economy and the fastest growing major economy.  The Chinese government likely has the financial resources to bail out troubled banks, however a Chinese banking crisis could undermine economic growth in China and globally.  Some analysts think that recent moves by the Chinese government to restrict bank lending contributed to market turmoil.  The possibility of a Chinese banking crisis gives added reason to invest cautiously in US and global stock and bond markets.

This letter is for general informational purposes only and not specific advice for any one individual or situation. Future results may differ from past performance. Different investments and/or investment strategies involve varying degrees of risk, and there can be no assurance that any specific investment or investment strategy, including the suggestions in this letter will be either suitable or profitable for an individual.  Our firm and/or individuals within the firm may have an ownership in one or more of the investments discussed.

About the author

Pinnacle Investment Management: Pinnacle Investment Management, Inc. is a comprehensive investment management and financial planning firm committed to the financial future of our clients.

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