Posted on July 9, 2013 by David Laidlaw

After its last meeting in mid-June, Federal Reserve Chairman Ben Bernanke indicated that the US economy appeared stronger than it’s been in years and all of the major markets …. sold off drastically. From June 18th to the 24th, US stocks dropped 5%. Continuing their slide, emerging markets equities have lost roughly 9% since the beginning of the 2nd Quarter. Commodity prices have also experienced losses. Gold now trades for just over $1200 per ounce and is down over 25% for the year, falling almost $200 per ounce after Bernanke’s testimony.

The question is why did the markets react so negatively to what should have been positive economic news. We believe the hint that the end of the Federal Reserve’s stimulative policies is nearer than anticipated caused the spasm in the markets.

Through its quantitative easing program, the Federal Reserve has been buying bonds to keep interest rates low. Since interest rates are artificially depressed, investors have sought higher yields than available in short-term US Treasury Notes by purchasing more longer-dated bonds, lower credit quality bonds, stocks (especially emerging market stocks) and commodities, than they otherwise would.

All rational investors know that the Federal Reserve cannot continue buying bonds indefinitely. However, the reach for extra yield combined with the persistent belief by those same investors that they could sell their risky securities before others in the same market, produced the volatility.

The difference from prior episodes of volatility over the past fifteen years is most stark in the bond market. The Barclays Aggregate Bond Market Index is down 2.59% during the first half of this year. Losses in other longer duration and lower quality indices are greater. For example, the S&P National Municipal Bond Index has lost about 4% year-to-date. Similarly, active bond funds such as Pimco’s Total Return Bond Fund have lost more than the aggregate index. Therefore, portfolios with higher allocations to bonds compared to stocks may have minimal gains or even losses this year depending on the weightings.

These returns contrast with prior years when bonds produced uninterrupted gains within a narrow range (see chart) while stocks fluctuated more violently. We have no idea whether or not bond prices will stabilize over the next couple of quarters; however, over time, bond portfolios will most likely lose value until interest rates stabilize at higher rates. This increase will not occur until the Federal Reserve stops its program of quantitative easing.

We have tried to mitigate the risks associated with rising interest rates by maintaining short durations within our fixed-income portfolios, but bonds still play a vital role in our balanced portfolios since they limit volatility if the stock market plunges and may produce gains if economic growth slows.

Volatility is back in the stock market since higher interest rates signify higher discount rates for future earnings. We view stocks as fairly valued at these levels, but do not expect annual double digit returns over the next couple of years, such as we have seen over the last couple of years.