Posted by David Tillson 2013 Second Quarter 

 For those of you who have heard the following: “Mom and Dad, I have some good news and some bad news,” you probably remember that mixed feeling of unease combined with potential relief. When your child gives you the good news first: “now you can finally get that new car,” that mixed feeling quickly solidifies into a much stronger emotion. This “good news, bad news” is essentially what investors have been hearing from Mr. Market for much of the past five years. While it may have put investors on somewhat of an emotional rollercoaster, the fact that we have had to balance the good with the bad has led to a much healthier market. When the news is out of balance, markets become unhealthy creating euphoric bubbles or deep bear markets. 

Our first quarter letter’s beginning paragraph stated the obvious question on the minds of many investors as the stock market was setting new highs: “So, now what? Opportunity or risk?” While confessing that market timing was not our forte, we made the case that staying the course would prove rewarding since stock valuations were not extended, that bonds were more hazardous to one’s financial health than they had been for decades, and that investors remained focused on risk rather than return. Three months later has brought us even higher stock prices, a significant climb in interest rates, and the largest municipal bankruptcy filing in history. But more importantly, the last quarter also validated our belief that we had reached a tipping point where investors were differentiating between simply “risk-on/risk-off” trading and actually paying more attention to what they own. We personally have been waiting for many quarters for this to occur since it plays to our strengths: analyzing and understanding the companies we purchase for clients’ portfolios. 

The second quarter saw the S&P 500 index rise nearly 3% giving investors a 14% gain for the first half of 2013. Bond investors however, felt some pain as prices declined with rising interest rates. The abrupt rise in the 10-year US Treasury Note yield from 1.6% in May to 2.6% in July surprised even the Federal Reserve, but on the bright side, it gave them a look into potential investor behavior when the Fed’s $85 billion monthly bond buying program is finally curtailed. Central banks’ actions arguably saved the world from a severe depression, but the developed economies still have not fully recovered from the Great Recession. The US continues to deal with weak employment rates, an economy that is still operating well below capacity, and investors, consumers and corporations that remain quite risk averse. Europe continues to be in worse shape and must deal with keeping the European Union together while balancing the needs of the weaker members with the resources of the stronger ones. Nationalistic biases and prejudices make the European leaders’ jobs much harder. China and several other emerging markets are not growing as rapidly as they were in the mid 2000’s and thus, are unable to provide the same support for world economic growth as they did five years ago. That is the bad news. The good news is that peoples’ expectations have been reset and that central banks have made it clear that they will do whatever is necessary to prevent another meltdown. Additionally, economic activity in the developed economies has stabilized and is beginning to show signs of faster growth, while financial institutions, consumers and corporations are all much stronger than in 2008. 

The sharp rise in interest rates in the 10 Year US Treasury Yields second quarter was a rude awakening for bond investors as they realized that their safe money might not be entirely safe. Not only have paper losses appeared on their statements, but the repayment of their principal has been called into question as defaults have become more commonplace. More and more investors are concluding that the 30+ year bull market in bonds has ended and that the coming decade could see the beginning of a sustained rise in interest rates. While this may be bad news for existing bond holders, the good news offset is that prudent savers will be able to earn a reasonable return. The notion that all municipal bonds are safe has also been shattered with several bankruptcy filings over the past few years. Detroit is the latest and by far the largest city to declare Chapter 9. Clearly this news is all bad for everyone involved and it will likely take years to sort out the issues. Who will suffer the most? Local retirees, bond holders, or local tax payers? There will be no winners in Detroit. But in the future, the public sector throughout the US will provide more accurate information so that all stake holders – bond holders, tax payers, and employees counting on a pension – will have a much clearer picture of risk versus return. In the past, promises were made that any reasonable analysis would have concluded could never be kept. The good news is that the “can” will no longer be kicked down the road. In fact, the Securities and Exchange Commission (SEC) in 2010 began cracking down on state and local governments for not giving investors accurate information about their financial condition prior to bond sales, focusing on pension deficits. Since then, Illinois and New Jersey have both settled with the agency over such issues. On May 6, 2013, the SEC charged the City of Harrisburg, PA, with securities fraud for its misleading public statements and on July 19th the SEC charged the city of Miami with securities fraud and for violating an earlier cease-and-desist order. Painful medicine to be sure, but necessary to cure a recurrent disease of municipalities making promises they can never deliver on. 


Our view of the future includes a continued stream of “good news, bad news.” The financial markets should remain healthy and we believe investors, while cognizant of risk, will gravitate away from investment strategies which emphasize bonds. The 2008-09 collapse prompted a near unprecedented level of risk aversion which led investors to move huge amounts of their assets into bonds. In hindsight, it was overdone and those who sold missed the recovery in equities, thus locking in their losses. People hate losing money; they also fear running out of money and they should fear a reduction in their standard of living. The fear of loss-of-principal is a primal emotion. However, investors should differentiate between paper losses and actual losses. The investment world generally equates volatility as risk and while true for traders, for long term investors, volatility is simply noise. No one likes to see that their portfolio has declined when they get their statement, but unless they must sell, no principal has been lost. We admit that it can take a strong stomach and a great deal of faith at times to stay invested, but if one’s analysis is based on sound principles and fundamentals, with patience, they will be rewarded. Investors should instead be far more concerned with the risks of running out of money or being able to maintain their lifestyle. As stewards of our clients’ wealth, we believe that our primary job is to focus on these two risks. Especially in this ultra-low interest rate environment, it is critical to accept the short term volatility and invest in equities which can grow over time. The rising stream of dividends will simply be an added bonus.