If MCS clients’ assets were one big portfolio, 2012 investment performance was up 6.4%. Individual client returns ranged from 2.9% to 12.2% for the year. These asset value increases compare with 16% for the S&P 500 (stock index) and 4.2% for the Barclays Capital Aggregate Bond Index (taxable bonds). 1
As year end approached, the Fiscal Cliff2, a metaphor for abrupt changes in taxes and spending starting in 2013 had markets guessing about whether the changes would be so abrupt that a recession could follow. The term “Fiscal Cliff” is a piece of spin in and of itself; it wasn’t called “Fiscal Fitness 2013; No pain, No gain” by either Democrats or Republicans.
Congress’s unfinished FC business is now determining spending cuts and the related debt ceiling. These issues will soon be upon us (March 1 for spending cuts or ‘sequestration’) and could be more divisive than the tax increases. My expectation is that the stock market’s benign behaviors has a 50% chance of becoming more manic, perhaps even hysterical, before an agreement on how much and to whom spending cuts apply.
The following table summarizes potential 2013 scenarios, my estimate of chances of those scenarios occurring, and how it would affect various investments. As you can see by looking at the ‘odds it will happen’ column, I don’t have a lot of confidence in any one scenario. The investments that ‘do well or poorly’ depend on what plays out in 2013. Generally, financial crisis and lackluster economic reports are good for bonds whereas improving economic conditions are good for stocks. Of course, I could be wrong about the scenarios, or the investment performance, both or there may be scenarios I did not consider.
Overall, this scenario exercise leads me to a modest bias favoring growth and away from bonds.
Stock Exposure Will Be Gradually Increased
At the end of the first quarter 2012, we began gradually increasing stock market exposure through Auxier asset management as a sub advisor. I have done two performance reviews with Jeff Auxier. The reviews focused on the performance of each stock selection rather than the performance of the account, which began as 100% cash and has been steadily invested over the past 10 months.
The bottom line is that, out of roughly 23 stocks selected, only 3 stocks were down in price. I also asked that he work the portfolio down to a total of about 20 companies representing his highest conviction purchases. He prefers to be more diversified because he doesn’t want to take too much risk in a new relationship. However, I assured him that, because he was managing only a fraction of the total portfolio, larger positions were needed; otherwise good performance by a specific company would not have enough influence on the total portfolio results.
Bond Exposure Will Be Reduced and or Altered
After reviewing the negative economic scenarios for bonds, you might wonder, “Should we sell most of our bonds?” The short answer is this: my strategy is based on how well the investments serve clients over many years, not on a single year’s outlook. I do intend to selectively sell some bonds and add other types of assets that provide income distributions, including dividend paying stocks and publically traded master limited partnerships (MLPs).4
Bonds, unlike other assets, offer investors the contractual obligation to get the face value of the bond returned to them at maturity. As bonds approach their maturity date, they become less risky / sensitive to interest rate changes. Maturing bonds provide cash flow to clients or ‘new money’ to find new opportunities.
It has worked incredibly well, especially since 2000. Any real attempt to reduce US government debt will put pressure on economic growth, resulting in higher than desired unemployment and muted economic growth; this would continue to keep interest rates low and bond friendly.
Nevertheless, it is a higher risk / lower return bond environment than we have seen in the past. In the long run, I would prefer to see 10 year government interest rates above inflation although client portfolios (and my own) would suffer in the short term. Higher rates would better ensure that we can continue to reinvest maturing bonds and unneeded income at returns that maintain our standard of living.
Interest rates and asset prices
The reality is that all investments are sensitive to changes in interest rates: stocks, bonds, gold, real estate, you name it. For example, in 2012, reacting to fears of rapidly increasing debt burdens and Greece like problems, Spanish government bond interest rates rose from 4.8% to 7.5% causing Spain’s stock market to fall over 30%. Once Spanish interest rates began to decline due to European Central Bank interventions, the stock market bounced back. The point is that for investors who fear a rapid rise in US government interest rates similar to Spain’s 2012 experience, there would be no place to hide: interest rates on US Government debt impact all asset prices.
As a reminder, I’m using Auxier as a sub adviser for selected client accounts in excess of $1 million, because he has excellent risk adjusted stock investment returns. He accomplished this by being a disciplined, risk management conscious buyer of publically traded businesses rather than a buyer of stock market exposure.
1 MCS clients own primarily tax-exempt and taxable municipal bonds for fixed-income exposure, which makes for a less-than-perfect comparison with the Barclays index.
2 The Fiscal Cliff describes two budget actions; 1) Increasing US government revenues through higher tax rates by allowing the expiration of both lower tax rates enacted under the Bush administration and lower social security withholding enacted under the Obama administration and 2) Automatic spending cuts (or ‘sequestration’) enacted under the Budget control Act of 2011, providing for total program spending cuts of $984 billion from 2013 to 2021. This breaks down to $109.3 billion per year which would be equally divided between defense and non-defense programs.
3 The Federal Reserve has stated that it will not end its ultra low interest rate policies until core inflation (consumer price index (CPI) minus the food and energy components of CPI) rises to 2.5%. (It was 1.89% as of December 31, 2012.. While stocks could initially perform well as core inflation increases (because this signals improving economic growth), increasing core inflation also means the prospect of higher interest rates, which would likely be a negative for stocks. The outcome for stock returns depends on how fast the market cycles from good news (“The economy is finally really improving”) to bad news (“This is the end of low rates and now we’re worried about inflation / higher interest rates”). The faster it cycles, the worse it is for stocks. The graph below shows core CPI over the past 5 years. (Source: Bloomberg)
4 Trading like stocks, MLPs are a form of legal organization that requires the public company to distribute 90% of its income to the owners.
MCS portfolio returns are dollar-weighted, net of investment management fees, include reinvestment of dividends and capital gains, and represent all fully discretionary income/growth accounts. These accounts represent MCS Financial Advisors’ assets under management as of 12/31//2012 and were invested primarily in U.S. stocks and bonds. There is no guarantee that prior performance will continue in the future, nor that any statement of opinion herein has value beyond the date of this publication. Bond performance does not include the effect of state or federal taxes. The S&P 500 Total Return Index measures the large-capitalization U.S. equity market, and the Barclays Capital U.S. Aggregate Bond Index measures the U.S. investment-grade bond market. Index values include reinvestment of dividends and income and are for comparison purposes only.