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"The Fed Chairman explained the moderately good news -- that the economy continues to grow at a slow, but ..."

Portfolio Update - July 2013

When Good News Causes Some Bad Things to Happen (temporarily!)

Dear Client Investor -

The May sell off in bonds continued through June with the anticipation of rising interests as a result of the expectations of continued economic growth. Stocks joined the commotion with anticipation of a Chinese slowdown, but have since largely recovered with the continued positive economic news. We expect the bond markets to stabilize over the next few months, will continue to adjust portfolios for the longer haul, and see the positive economic trends ultimately good news for all investors.

“How could it be?” you may reasonably ask. “The economy is getting better, but my statement values have gone down these last two months?” As indicated in our May Portfolio Update, even the most conservative bonds have been under considerable selling pressure since late May with the broad misinterpretation of the Federal Reserve’s announcement of possible stimulus tapering late this year and early next. The Fed Chairman explained the moderately good news -- that the economy continues to grow at a slow, but sustainable rate and that somewhere down the road, if sustainable growth continues, if the unemployment rate drops significantly, the Fed would begin to taper its stimulus efforts leading to interest rates slowly rising from their currently historically low and suppressed levels. Something he’s said before, something everyone knew to be the case. But as the traders and their computers had a field day, the markets, bond and stock, went nuts. And as usual, the feast for the computer traders was at the expense of all other investors.

Why? The anticipation of increasing interest rates means that the lower interest rate positions currently held by existing bondholders will be priced lower in value, and bond investors raced to the exits. But before getting despondent, investors should realize that most of those changing bond prices are on paper, however, and investors who hold their positions will, over time, actually gain from the rising interest rates as new positions with the newer, higher yields, are purchased. But for the moment, it’s understandable that investors can become disheartened by drops in statement values of what they thought were relatively “safe” investments.

To make matters more anxiety-provoking for investors, however, a stock correction in June, precipitated by the Chinese Central Bank’s stated intention of tightening domestic credit (to stop real estate speculation, among other things), gave the equity markets a reason to sell off as well, particularly the big large cap, conservative stocks. Fortunately, with sound economic fundamentals here in the US, however, that sell-off was short lived, and stocks continue to rebound as I write this, particularly given the most recent positive job reports which demonstrated that the economy added a rosy 195,000 jobs last month.

The sum total of both the bond and stock sell-offs, however, particularly (and ironically) among the most conservative investments, has been that almost all investors who had done the right thing and properly diversified their portfolios saw unusual drops between May and June, with some assets classes (i.e. real estate, emerging markets, mortgage REITS) really leading the downturn. Unpleasant, for sure, but we feel this to be short-lived as the bond and stock markets work through the overreaction and uncertainty, and stabilize.

Over a period of several quarters, barring some catastrophic global issue, these drops should be nothing more than blips, and portfolios should resume their positive courses.

With continued expected, albeit slow, economic growth of between 1-2% this quarter (and increasing to perhaps 3% growth later in the year), and the anticipation of rising interest rates, our feeling continues to be that higher quality, dividend paying equities provide some of the best values in this economic environment. These large cap stocks pay dividends and stand to appreciate with the slowly improving economy. Accordingly, we will continue to build upon these positions for many investors, particularly as we lighten up on longer duration bonds which will continue to be subjected to selling pressure in an increasing interest rate environment. Eventually, as longer duration bond yields start to stabilize at higher rates, they may become more attractive. Until then, however, we will look to shorten durations and volatility.

We continue to believe, however, that the markets have overreacted to the Federal Reserve Chairman Bernanke’s comments (after all, the unemployment rate is still 7.6%, and still far from the stated Federal Reserve’s target of 6.5%), and that most quality bond values will stabilize or even improve. More importantly, though, we also hold to the position that bonds are significant income generators and diversifiers in investors’ portfolios, and the total returns of these positions will be positive over the intermediate and longer term. Aside from providing a predictable and steady income stream, bonds are usually valuable hedges against strong stock downturns. History has borne out these assertions repeatedly. So our message for our fixed income and more conservative investors is to hold tight, ignore the temporary fluctuations, and know that the rising interest rates will improve income over time.

So what of the Mortgage REITS such as Annaly Capital and American Capital Agency – two exceptionally well-run firms that have been particularly hard hit over the last couple of months? Mortgage REITS have been terribly oversold in the panic bond selling, and many are actually outstanding buys at this time for growth-oriented investors. However, for portfolios of more conservative investors, despite yields now of upwards of 20%, the high volatility in this sector due to the Chairman’s comments has caused us to seek to reduce exposure to this sector over the coming months (slightly earlier than expected), particularly as we expect to see Fed tightening down the road until interest rates stabilize in 2014. It’s important for our investors to note that Mortgage REITS occupy a relatively small place in our portfolios, and so their impacts on portfolios will be relatively small, even while they continue to provide significant income.

As mentioned above, two other asset classes, real estate and gold, have also been hard hit. Increasing interest rates typically impact real estate profitability, but the June drop had more to do with the tremendous run-up over the last year, and a natural pullback from the 20%+ increases since the beginning of the year is to be expected. We expect it to remain a solid asset class going forward. The inflation hedge – gold -- on the other hand, continues its long descent. We reduced exposure to gold some time ago, it currently occupies a small position in portfolios, and will continue to do so until inflation appears in the cards or we begin to see strong buying pressure.

Importantly, however, as we have learned time and again, crystal ball-watching is a fool’s game. Accordingly, despite these portfolio changes and the usual summer volatility we will continue to keep portfolios diversified across asset classes. We take a long term view in our management, but are prepared to make moves quickly if we see major crisis on the horizon. What we’ve seen thus far has been a largely orderly adjustment to good news in the economy, something we expect will ultimately benefit all investors. Accordingly, we remain moderately upbeat about the economy and markets over the several months.

Once again, please feel free to call with any questions.

Ron Stein, CFP

Good Harvest Financial Group


Disclaimer: each investor has different needs. The information herein should not be used to direct investment decisions without assistance. No guarantees can be made or implied in the above information.
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