2014 Performance Report and Investment Outlook1

For calendar year 2013, aggregate MCS client assets gained 4.5%. Returns on client portfolios invested for the entire year ranged from -1.8% to 8.5%. The differences are attributable to tenure of the client and differing investments or asset allocation.

Stocks represented by the S&P 500 Total Return Index turned in a very strong performance of 32.4%. Auxier advised stock portfolios gained 22% for the period. The under-performance is due to cash held in the Auxier accounts. Performance of Auxier stock portfolios, before deducting asset management fees and not including the cash balances, ranged from 31.6% to 37.7% in 2013, with a weighted average return of 35.9%. The bond market represented by the Barclays Aggregate index lost 2%.

2013 began with a lot of uncertainty and little conviction on my part about the future path of asset prices and the economy. Many investors were deeply pessimistic about the country’s direction and prospects. While I wasn’t deeply pessimistic, my concerns about the risks, and the fact that many clients are now in the late stages of accumulation or reliant on their portfolio for lower volatility and steady returns, kept me from committing a higher percentage of client money to riskier assets like stocks.

The year turned out far, far better than I forecast. The S&P 500 index had its best year since 1997; up 32.4% including dividends. Anyone predicting such an outcome at the beginning of 2013 would have been called a gulli- Bull. While stocks were the star asset class of 2013, other assets struggled or lost ground.

  • Vanguard’s REIT (real estate investment trust) index gained 2.3%
  • Barclays Aggregate Bond Index finished the year with a modest loss of 2%
  • Treasury Inflation-Protected Securities lost 9%, as gauged by the iShares TIPS ETF (TIP)
  • iShares 20+ Year Treasury Bond (TLT) lost 14%
  • Gold lost a whopping 28%

2014 Forecast

Every year is another opportunity to do it better, so here is my 2014 forecast.

Figure 1
Potential Economic Scenarios and Outcomes ‐ United States

MCS| Performance Report and Investment Outlook | Figure 1

Figure 2
Potential Economic Scenarios and Outcomes ‐ International

MCS| Performance Report and Investment Outlook | Figure 1

2014 Strategy

I believe the US economy will continue its slow growth path leading to modestly higher interest rates with the 10 year Treasury bond (currently 2.75%) between 2.75% and 3.50%. Higher longer term rates will be welcome because it will lead to higher long term portfolio returns from bond sales, maturities and reinvested income payments although it will reduce the price of bonds already held in portfolios.

As bonds mature or are sold, we will be able to reinvest at attractive rates compared to inflation. Keep in mind that short term rates are zero, so those rates are negative after inflation. However, longer term investment grade bonds (9 to 13 years) offer scattered opportunities to buy 5.5% to 6% rates; well above current inflation of 2%. Based on my scenarios, I’ll be increasing the stock allocation for many clients–depending on their circumstances. Increased stock exposure will be through combination of buying indexes like the S&P 500 and individual stock selection.

Municipal Bond Prices; an Untold Story

Investor expectations about the price and value of their bonds are set by their experience with stocks, which trade constantly and therefore accurately reflect the minute to minute news and auction value of the company. You might be surprised to learn that some bond prices on your monthly brokerage statements often do not reflect the actual prices that the bond is trading at! Here’s why.

Many bonds to not trade for months because they were ‘put away’ i.e. purchased and held long term by the investor (we’re that kind of investor). So how does Schwab come up with a price on your monthly statement for a bond that didn’t trade that month? Brokers like Schwab buy bond prices from a pricing vendor. The price vendor estimates the bond’s monthly price based on the bond’s interest rate, maturity, credit quality and transactions in other bonds with similar characteristics. In fact, the price vendor may ignore actual transactions when providing the daily ‘price’.

On average, Schwab’s method works well enough, but it is far from perfect. An example of this happened recently.

In December, I purchased bonds a broker was selling to retail clients at 117.711 for 116. (I negotiated a lower price –something I routinely try to do.) The broker had paid 115.375 for the bonds. At 116, the bond’s yield to call of 5.56% in 2021 and yield to maturity of 6.50% in 2026 was very attractive compared to other ‘A’ rated bonds. The trade history follows on the next page (see Figure 3).

Figure 3
Trade History

MCS| Performance Report and Investment Outlook | Figure 3

Figure 4
Price History

MCS| Performance Report and Investment Outlook | Figure 4

Using another data base (EMMA), I can tell you that prior to the above trades, the bonds last traded in August of 2012 mostly between 115.2 and 117.2. Yet, after the transaction settled on 12/17/13, Schwab’s system (Figure 4-Price History) indicated a price of 108.119 or 8 points lower than actual transactions!

The natural questions from clients: Why did my bond’s price drop? Did something happen to the bond issuer?

The usual answer is that nothing happened to the bond issuer; the reported ‘price’ is not accurate.

Fortunately, there is a mechanism to challenge the price. I provided Schwab with the actual transaction history of these bonds from December 2013. Schwab forwarded this information to their pricing vendor. About 2 weeks later the vendor updated its price, but did not update the bond’s price to the actual market transaction prices. Nevertheless, the bonds were priced at 114.402, much closer to actual trades between 115.375 and 117.771.

Bottom Line

During periods of bond market volatility, vendor-estimated prices can differ significantly from actual transaction prices, especially for less frequently traded bonds. Vendors use the prices of ‘similar’ bonds for estimates, but it is common for two vendors to have different prices for the same bond on the same day. Sometimes the vendor price goes stale, month after month goes by and the price never changes. MCS clients collectively own over 450 different bond issues. Some bonds will be mispriced on your statement. It could affect reported performance over the short term, but in the long run price errors tend to adjust.

1 MCS Family Wealth Advisors (MCS) returns are dollar-weighted, net of investment management fees unless stated otherwise, include reinvestment of dividends and capital gains and represent all fully discretionary Income/Growth accounts. These accounts represented 92% of MCS’s assets under management as of 12/31/2013 and were invested primarily in US stocks and bonds (19% of the Income/Growth assets on 12/31/2013 were invested in tax-exempt municipal bonds). The Stock Index values are based on the S&P 500 Total Return Index, which measures the large-capitalization US equity market. The Bond Index values are based on the Barclays Capital US Aggregate Bond Index, which measures the US investment-grade bond market. Index values are for comparison purposes only. The report is for information purposes only and does not consider the specific investment objective, financial situation, or particular needs of any recipient, nor is it to be construed as an offer to sell or solicit investment management or any other services. Past performance is not indicative of future results.