Spring arrived early for 2012. In spite of the predictive powers of Punxsutawney Phil, the cherry trees along the tidal basin next to the National Mall are in full bloom - weeks ahead of their “normal” cycle.

Spring brings us out of the dullness of a barren winter and helps remind us that change is inevitably constant. Faced with this reality, smart investors continually seek to manage unforeseen risks and uncertainties. We at Farr, Miller & Washington have a balanced approach to portfolio management. We seek investments that are likely to benefit from the long-term growth in the global economy. At the same time, we place high value on an investment’s ability to withstand turbulent economic times. This approach has suited us well since we opened our doors in 1996.

The bond market has become a source of consternation for many investors in recent years. Following a 30-year trend of falling interest rates, many investors justifiably wonder if bonds are a smart investment. We have our opinion, but we don’t have a definitive answer. In any event, bonds do have a place in many investor portfolios, depending on a variety of different factors. In general, many of our clients hold bonds to provide stability and income to their portfolios. Typically, when the equity markets deflate, bonds get a breath of fresh air and smooth the overall portfolio values.

Last week we saw the other side of the coin as the DOW surged through the 13,000 barrier, hitting highs that have remained untested since pre-crisis 2007. Yields on the 10-year Treasury, in turn, leapt from below 2% to the current (as of this writing) return of 2.38%. Remember that as bond yields rise, bond prices fall.

During historical economic recoveries, bond prices fared a good deal worse than they have in the current recovery. This is because the Federal Reserve and Treasury Department have taken enormous actions to keep yields low, thereby increasing the odds that the recovery becomes self-fulfilling. The recent year’s experience of near-zero interest rates has been unexpected. But it may be that we are seeing the rate tide turn.

Past Farr Views have warned of risks to bondholders in rising rate environments. The current jump in the 10-year yield from 1.85% in January to 2.38% on March 19th meant that the price fell from $101.35 to $96.66, or 4.6%. Obviously, investors who purchased 10-year notes with a 1.85% yield to maturity will suffer if they have to sell today. Moreover, returns will only become more negative as yields rise further. Should rates rise to 4%, the price on the US Treasury 2% of 2/15/22 will fall to $83.78.

Naturally, there is no way to know whether this jump in rates is just a blip or the beginning of a trend. But being aware of potential threats is every investor’s job. Our strategy for bonds has been defensive for some time. Average maturities and durations have been shorter, and purchases have been well-researched and opportunistic.

If you own bond mutual funds, check the price action over the past couple of months. If your exposure to rising interest rates is unacceptable to you, it may be time to consider re-allocation. Interest rate movements affect almost every type of investment in some way, but bond investments will react with direct negative correlation. The rule for bond investing is that the lower the coupon and the longer the maturity, the more volatile prices will be. Therefore, higher coupons and shorter maturities mitigate volatility, and therefore, risk.

The tide in the Tidal Basin may be changing. As soothing as 80 degree March afternoons can be, we diligently prepare to avoid the bite of a late market frost. Understanding that risk exists is the first step in combating it or taking advantage of it. Be careful out there.

Do you believe the economic recovery is real and sustainable? Those are really two questions, and we suppose someone will want to parse our definition of “real.” The S&P 500 is up 10% over the past twelve months and 24.7% since September 30, 2011. The recent rally is filling Wall Street with feel-good breezes that are lifting all moods. The higher it goes, the higher portfolio values go, and folks begin to feel whole and maybe even a little bit rich again.

The seductive siren song is wafting from Federal Reserve speakers and furtherance of Greek life-support has driven share prices higher. Investors are increasingly more sanguine despite historically high profit margins (which are mean reverting) and still-tepid demand growth. According to a generally positive report from the Wells Fargo Economics Group, “The weak underbelly of the recovery continues to be sluggish income growth and the massive destruction of household wealth from lower home prices and the 2008 financial crisis. Household wealth remains $8.4 trillion lower, with financial assets $3 trillion lower, and the value of real estate holdings $6.7 trillion below their respective pre-crisis levels.”

In our view, the strength of the economic recovery will likely be capped due to a few very important factors. First, baby boomers are ill-prepared for retirement following trillions in lost home equity, years of irresponsible spending (on credit), and a decade or more of very weak inflation-adjusted income growth. The need to increase savings rates will likely be a drag on economic growth for years into the future.

Second, the unwinding of very aggressive monetary policy is likely to result in higher interest rates at some point. As we all know, low interest rates have been the life blood of this recovery, and higher rates could have a dramatic effect on economic growth and asset prices.

Third, we have yet to know the ultimate effects of trillions in central bank monetary easing across the world. Our own analysis shows a very clear link between the Fed’s monetary easing and the prices of commodities, especially oil. Will central banks across the world be able to reverse course in time to avoid a surge in inflation? Has Fed policy led to some irrational exuberance in asset prices such as stocks?

And finally and perhaps most importantly, investors are beginning to hear the ticking of the election clock, dwindling toward November. Regardless of winners and losers, Congress will be forced to address our structural deficits some time in the near future. If the Republicans gain control, we expect federal government spending will be scaled back. If the Democrats gain control, we would expect a greater focus on tax revenue. Either approach will likely be a drag on economic growth in the near term.

Europe and China are on the down-slope of economic cycles, and the US, once again, seems to believe in “decoupling.” We seem to feel that the rest of the world may experience trouble, but it really won’t bother us on our happy island. These feelings have proved inaccurate in the not distant past. The interwovenness of the global economic fabric is intense.

With these issues in mind, we continue to believe that a climb from profound labyrinth-like depths will take time and at points become quite difficult. We find ourselves neither despairing nor rejoicing, but rather we feel resigned to the advent of a more sober time which will not be without profitable areas. Our portfolios are positioned to tap growth as it occurs around the world, but should also benefit from balance sheet strength if the tides begin to turn.

Peace,

Michael

The media were all abuzz following yesterday’s much-anticipated sell-off in stocks. Prior to yesterday’s 1.5% drop, the S&P 500 had gone 44 straight days without a sell-off of 1% or more - the longest such streak since May, 2007. Over the same time, the VIX index, which provides a market estimate of future stock volatility, cratered to multi-month lows. The VIX falls when fear subsides. Therefore, to say that complacency had crept into the market may be an understatement. With increasingly strong employment data and no sign of the Fed removing its foot from the gas, investors plowed ahead into stocks and took the S&P 500 to multi-year highs. The S&P 500 has now risen over 100% since the lows of March, 2009, and many (if not most) market pundits say we are headed significantly higher by year’s end.

But due to the relentless buying of late, a correction has been considered overdue by many professional traders. Such a pullback, absent any other issues, would be considered healthy for a market that has become so hot. Generally, these “healthy” corrections could be good for 5%-10% declines in the major market averages. This would suggest that more selling may be ahead if we are indeed experiencing a normal and healthy correction. Indeed, many professional traders would actually be encouraged by a pullback of this magnitude. It would allow investors to consolidate their gains, regroup, and prepare for the next leg higher.

Our concern has not been that the market is going higher. We continue to believe that high-quality stocks may be the best investment alternative in a world of 2% long-term Treasury yields. Rather, our concern is that the Fed may be keeping the training wheels on for far too long. The Fed’s support, explicit or implicit, creates a moral hazard among stock investors. If investors feel that the will be bailed out by QE3 or other Fed action in the event of a sell-off, this will lead them to take on more risk than they otherwise would. Moreover, the Fed’s maintenance of super-low interest rates can force investors into riskier assets in an effort to improve returns. These types of behavioral responses to Fed action can lead to asset bubbles if allowed to go on too long. They can also keep the market from undergoing a normal and healthy correction.

The good news is that a closer look at the action within S&P 500 suggests that sentiment overwhelmingly favors the notion of economic recovery. The sectors driving the index higher are the more cyclical and volatile ones that professional investors usually target in an effort to get the most bang for their investment buck during periods of economic recovery. For instance, the Information Technology, Financials and Consumer Discretionary stocks are all outperforming the overall index so far this year. Earnings within these sectors would generally be expected to benefit to a much greater extent from an economic recovery. On the other hand, Utilities, Telecom, Consumer Staples, and Health Care - sectors considered more defensive in nature - have lagged the overall market so far this year.

S&P 500 Sectors YTD Change
Information Technology 14.2%
Financials 11.5%
Consumer Discretionary 10.2%
S&P 500 7.2%
Materials 7.2%
Industrials 6.7%
Energy 4.9%
Health Care 2.8%
Consumer Staples 0.9%
Telecom 0.1%
Utilities -4.4%
Source: Bloomberg

It is not uncommon for investors to hope for a near-term correction so that the long-term upward trend is maintained and indeed strengthened. In our view, investor reluctance to sell is a sign that greed has been far outweighing fear. And a relative lack of fear MAY be a sign that investors expect help if they get into trouble. As long as Big Brother Fed is around, investors should take their outsized stock gains with a grain of salt.

Peace,

Michael