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An Unusually Calm Quarter

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The first quarter of 2015 was relatively quiet but we still noticed several distinct emerging trends that we thought would be a good idea to address.

 

Perhaps the biggest thing on everyone’s mind is the question of when the Federal Reserve will start to increase rates. The Yellen Fed seems interested in telegraphing their moves well ahead of time and many people have interpreted their comments to mean that a rate hike could be expected in June. We obviously don’t know what the Fed is going to do but it seems reasonable to us that the Fed would make a comment or two somewhere if they had a major disagreement with this.

A Fed Funds hike is an important economic event but we think it’s something that people pay a little too much attention to. We think the single most important data point in the entire financial world is the 10 year US Treasury rate. This rate is set by market forces and it’s the rate used to determine the price of money in countless financial transactions. Fed Funds is something that talking heads can make a big deal about to keep eyes on their TV program but it has very little influence on most daily financial activities. Very little, if any,direct lending activity is tied to Fed Funds.

 

The thing we need to watch is if changes in Fed Funds affect the 10 year bond. Sometimes the 10 year will move with Fed Funds but other times it won’t. In 1999 the two rates moved upward together. However, in the period from 2004-2006, Fed Funds went up and the 10 year remained mostly flat. In 1994 the 10 year overshot the Fed Funds move.

 

The bottom line in our opinion is that we need to pay a lot more attention to the 10 year bond. This is the rate that will influence financial transactions. Many economic textbooks say these two rates are supposed to move together but the chart above shows that this isn’t always the case.

 

 

Another issue we’ve noticed is that having a diversified portfolio is starting to pay off again. It’s been our contention that a diversified portfolio tends to be a better long term strategy than simply buying the S&P 500 index. For the past few years, this has been challenged by the underperformance of almost all other asset classes. The S&P 500 has been the only game in town but other asset classes are now doing better.

 

In the chart below, the S&P 500 Index is identified as “large cap.” Developed markets ex-US (“DM equity”) and emerging markets (“EM equity”), two of the worst performing asset classes in 2014, both substantially outperformed the S&P 500 in the first quarter. Even bonds did better than the S&P 500.

 

We’ve continually advocated that the dominance of the S&P 500 probably wouldn’t last forever and we are finally starting to see a rotation out of the asset class in favor of more fairly-valued ones.

 

 

We know that many people think the current recovery has been driven primarily by government policy. They think the different QE programs provided the liquidity to make growth happen. In our opinion, the only thing these programs really did was to provide a backstop to the economy as a whole. Most of the reserves created were never actually lent out and we have not seen the inflation that so many people thought would happen. In our opinion, the growth we’ve seen is organic. It’s come from the same people as it always comes from- those who roll up their sleeves and work hard to create wealth for themselves and their employees.

 

We remember the constant worries from several years ago about what would happen when the different QE programs were ended. Well, they’ve all come and gone and their absence was hardly noticed because, as noted, they never actually were responsible for any growth.

 

We think many investors are still shell-shocked by the experience of the 2008 panic. Unfortunately, many have remained on the sidelines as stocks have recovered above and beyond their levels back in 2007. This is really the core of what it means to be a long term investor. There are going to be times where there is market volatility but it’s incredibly important to be sure we don’t get permanently scared out of equity markets. We still use stop loss orders and other strategies to mitigate losses but the complete abandonment of stocks in a portfolio can have a devastating long-term effect.

 

There have been several recent situations where investors were once again tested. We’ve occasionally seen bad employment and GDP numbers, we’ve had geopolitical turmoil in places like Ukraine and we’ve seen major concern that diseases like Ebola could cripple the global economy.

 

For us, the most comical situation has been that of Greece. Remember a few years ago when the pundits were losing their minds about the possibility that Greece would leave the EU. The “Grexit” was cited as a reason for all kinds of market movements. Today, a very similar situation exists and yet markets seem to have hardly noticed.

 

Perhaps the most cliché term that came out of the 2008 panic was the idea of a “black swan” event. These days, everyone is looking for the next black swan situation but, by definition, they are never going to find it. A black swan is something nobody sees coming. We have no doubt another will arrive at some point in the future and that it will once again cause a global panic. The key to survival is to not completely avoid market risk but instead to expect that bear markets will happen and to have a strategy in place before they show up.

 

 

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