QUARTERLY MARKET UPDATE October 2014
ASSET CLASS PERFORMANCE Equity Markets - With momentum noticeably weakened, major US equity indices registered slight positive gains during the third quarter of 2014. The S&P 500 Index added another one percent to its YTD return, with the healthcare sector leading the way. The Dow Jones Industrial Average and the Nasdaq Composite both outperformed the S&P 500, bolstered by strength in technology and consumer defensive, respectively. Small capitalization stocks drastically underperformed during the quarter, dragging YTD performance into solidly negative territory. Both developed and developing (emerging market) international equities also saw considerable weakness, vastly underperforming domestic stocks. This softness was present in Europe and Asia alike.
Fixed Income Markets - Fixed income markets have largely maintained their YTD gains, though some sectors were more stable than others. Investment grade corporate bonds essentially treaded water, as did the US Government sector. High yield corporate bonds experienced dollar outflows, as did Treasury Inflation Protected Securities, most likely due to dampened perceptions of credit and a diminished inflationary outlook. Emerging market debt noticeably underperformed the other sectors, primarily due to the persistent strength in the US Dollar, ultimately registering unambiguously negative YTD returns.
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CAPITAL MARKETS OVERVIEW Key Economic Theme - US Dollar Strength
The US Dollar index increased 7.8% during the third quarter of 2014. What’s noteworthy about this move isn’t just its appreciation versus a few primary counterparts like the Euro and the Yen. The dollar has risen against the Real, the Pound and both the Australian and Canadian Dollars, not to mention gold and commodity indexes in general. There are many factors which affect currency movements, but two principal impacts which exert constant influence are economic growth expectations and international interest rate differentials. The notion that US growth is accelerating (and will continue to) remains the predominant view of investors; this perspective has had considerable effect on capital market direction over the past many months. While acknowledging pockets of strength, we continue to view the recent data as on balance unexceptional, continuing to send the types of mixed economic signals we’ve been subjected to since 2013. Indeed, there has been some good data recently; personal income and spending have seen increases, the Institute for Supply Management (ISM) surveys show optimism, and perhaps most importantly aspects of employment data (jobless claims and headline unemployment rate) remain solid. But there exist offsetting negatives; decreasing pending home sales and mortgage applications and declines in construction spending, auto sales and consumer confidence. Given these variegated signals, the bond market remains skeptical of assured growth expectations. In fact, the 10-year Treasury yield was unmoved on the latest strong employment report and the 30-year Treasury yield actually declined. So it would not seem that an appreciably accelerated growth expectation in the United States is the principal driver in dollar strength, but rather prospective interest rate differentials instigated by growth deceleration outside the US. And though the pace and timing remain in doubt, market participants uniformly believe the Federal Reserve (Fed) will be hiking rates next year despite the suppression of inflation expectations. This increases the perception of higher relative rates in the US versus the rest of the world in the intermediate term.
QUARTERLY MARKET UPDATE October 2014 | Page Three So the rise in the dollar is a combination of rising rate expectations and a change in relative growth expectations. Written differently, it isn’t that the US is seen as an ideal place to invest, but rather that the US is seen as comparatively less bad. Whatever the reason though, a stronger dollar helps keep downward pressure on inflation, which indirectly increases US purchasing power which will allow the export oriented economies to reaccelerate. However, there are costs to a stronger dollar as well. One problem is the adverse effect it creates for the US energy industry. Oil prices have been sinking, partly due to surplus and weakening demand, but also due to the rising dollar. A continued expansion in US oil production will be threatened if prices stay persistently weak, as substantial debt has been undertaken to service expansion and stable, higher energy prices accommodate ministration of the debt. Additionally, much the growth we’ve experienced during the recovery has been energy related. Some of the recent volatility we’ve seen in the US stock market is most likely in response to these developing conditions. There are certainly long term positives to a strong dollar but the short term negatives could garner attention for now. Close to half of S&P 500 revenues come from international markets and there will most likely be some impact on revenues and earnings in the just completed quarter. Moreover, these impacts may well show up in financial projections for future quarters, where estimates already demonstrate by historical standards fairly muted revenue and earnings growth expectations. Potential impacts of dollar movements aside, the combination of macro issues and market moves (relentless equity advances, recent increased volatility, the stock-bond disconnect, central bank liquidity, etc…) over the past year has lately seemed to create a sense of psychological fatigue amongst investors and advisors alike. They know that the economy isn’t great but they also recognize the need for investment return and so feel obligated to participate in a market they no longer trust. They know the Fed has distorted prices – in bond markets, stock markets and the economy at large – but are tired of trying to outguess the Fed on the direction of policy. And market participants are increasingly nervous about the outcome to the end of this unprecedented monetary policy experiment. There is a tension between the need to protect the gains from the last few years and the desire to participate in more upside. Good economic news leads to fear of an accelerated interest rate tightening cycle but also an appetite in the form of potentially higher earnings. Uncertainty is a constant factor when analyzing potential outcomes and framing decisions in the field of investment management. However, the current level of ambiguity seems abnormally elevated and potential outcomes fraught with acute consequences. We don’t know how all of the existing contradictions will be resolved but do think a more subdued approach to investing is required until some of them are. That means fashioning allocations which can reasonably withstand potential adverse movements. Part of that approach requires holding more cash than normal and respecting the increased odds of potential mistakes within the fog of uncertainty. It requires staying flexible and not reacting to data on a short term basis, rather positioning investment portfolios in a fairly calm and neutral position, one that will allow survival whatever the outcome as trends more fully develop. Peter Bernstein, longtime investment thinker and author famously stated: “Understanding that we do not know the future is such a simple statement, but it’s so important. Investors do better where risk management is a conscious part of the process. Maximizing return is a strategy that makes sense only in very specific circumstances. In general, survival is the only road to riches.” In any scenario with multiple potential outcomes one must at least consider all the alternatives. No matter what the consensus, there must be some assignment of probability to the opposite outcome. What are the consequences of being wrong? In the current environment, being certain about anything could prove quite costly, where the consequences of being wrong determine an investor’s true risk level.
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PORTFOLIO IMPACT - Traditional Assets
PORTFOLIO IMPACT - Alternative Assets
Stocks – As our economic theme commentary suggests, contradictory domestic macro data and general weakness internationally have caused us to remain fairly risk averse. With small cap stocks exhibiting the greatest current volatility, our equity positioning remains focused on larger, stable, yield generating (and yield growing) securities. Our sector positioning again remains consistent with this viewpoint, as we persist in over weights primarily in healthcare and infrastructure, and a few other selected yield producing equity positions.
Global Macro - The macro allocation theme seeks to capitalize on global opportunities through active management across asset classes, geographies, currencies, and risk themes. This strategy employs a top-down approach that focuses on general price movements in various asset classes and currencies rather than the performance of individual company securities. The portfolio’s goal is to identify and exploit periodic discrepancies between fundamental values and market prices; these perceived value/price discrepancies are the foundation for the portfolio construction.
Bonds – With Fed tapering almost complete and uncertainty regarding the timing and magnitude of eventual rate increases, we remain predisposed to short duration corporates (we have particularly limited Treasury exposure), favoring credit risk over interest rate risk. Focusing again on the incongruent outlooks of equity and fixed income markets, we have actually seen longer dated maturity bonds outperform those of the shorter variety (the yield curve has flattened, with the short end rising signaling muted growth expectations of bonds). Though this could continue for an indefinite period of time, we still prefer the relative safety of the short end of the curve, as interest rate risk, though still present is meaningfully minimized.
Market strategy is positioned net long of equity, though the magnitude has been reduced. This change in exposure was a result of reduction to broad developed European equity and emerging markets small cap equity earlier in the year. Market strategy is positioned net short of government bonds. Credit spread exposures have been materially unchanged. The forward-looking investment opportunity value has declined with respect to equity and bond markets in the last year; hence, the recent strategy changes in these asset classes have mostly been to reduce risk exposure.
Tax Tip: You may receive 1099 forms for your investments at the end of the year, with all of the income you’ve earned from them. The 1099 form works like the W-2, because it reports the income you’ve earned to the IRS. You’ll need to report income from all sources regardless if you receive a 1099 form. Treat 1099 forms as you would a regular W-2. Make sure to collect and provide your tax preparer or CPA with all 1099’s and W-2s in order to properly prepare your tax return
Merger – This strategy seeks to provide attractive risk-adjusted returns in virtually all market environments while preserving investor capital and minimizing volatility based risk. This approach normally invests at least 80% of its total assets in companies involved in publicly announced mergers, takeovers and other corporate reorganizations. For most of its merger arbitrage investments, the Fund’s potential profit is equal to the difference between the price at which it acquires the target company’s shares and their expected value upon completion of the transaction. In 2014, share prices of acquiring companies have gained 4.4% on average within a day of deal announcement, the highest post-announcement increase since data tracking began. Shareholders, frustrated with non-productive cash on balance sheets, are happy for companies to pursue mergers, acquisitions and other corporate reorganizations in the hope of improving returns through cost savings, pricing power and economies of scale. This positive feedback should encourage continued deal activity.
Copyright © 2014 Kern DeWenter Viere, Ltd. All Rights Reserved. Investment advisory services and fee-based planning offered through KDV Wealth Management, LLC, an SEC Registered Investment Advisor.
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Copyright Š 2013 Kern DeWenter Viere, Ltd. All Rights Reserved. Investment advisory services and fee-based planning offered through KDV Wealth Management, LLC, an SEC Registered Investment Advisor. Securities offered through ValMark Securities, Inc. Member FINRA, SIPC - 130 Springside Drive, Suite 300, Akron, Ohio 44333-2431, 1-800-765-5201. KDV Wealth Management, LLC, is a separate entity from ValMark Securities, Inc. and ValMark Advisers, Inc.