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Gold, Hedge Funds and May Volatility

May turned to be a very eventful month in the market, especially in the bond and high-yield equity sectors. Many investors opened their May statements to find that their portfolios were down for the month (unless you invested solely in the S&P 500).

Some of the biggest losers turned out to be the 20-year Treasury bond, TIPs, utility stocks, REITs, and other interest rate-sensitive issues. With traditionally “safe” stocks and bonds going down, you need to be very careful about where you invest.

Hedge funds are private investment vehicles that are largely unregulated compared to a mutual fund or ETF. They have been prevented from marketing directly to individuals, but recent comments from the SEC hint that that could be changing.

If you are looking to invest in a hedge fund, you need to do a close inspection of the investment policy for the fund. This evaluation is very important because there are so many different types of funds. These include global macro, arbitrage, asset-specific and high-leverage.

You also need to take a close look at the manager of the fund and make sure they have a track record of success. Finally, beware of long lock-up periods that may prevent you from withdrawing your money.

Gold has received a lot of attention lately. From financial media to infomercials, gold is everywhere. But you should be cautious about treating gold as an invest rather than a traditional storehouse of value. When determining the expected return of gold (as with any asset), you have to look at certain attributes such as income production, historic returns, etc.

We use gold in our portfolios in much the same way we do bonds:  as a hedge against inflation.

Volatility and the Search for Yield

May turned to be a very eventful month in the market, especially in the bond and high-yield equity sectors. Many investors opened their May statements to find that their portfolios were down for the month (unless you invested solely in the S&P 500).

Some of the biggest losers turned out to be the 20-year Treasury bond, TIPs, utility stocks, REITs, and other interest rate-sensitive issues. Much of this volatility can be attributed to fears that the Fed may curb its bond buying program (actions by Japan’s Central Bank are also a concern).

With traditionally “safe” stocks and bonds going down, you need to be very careful about where you invest. But we continue to believe a well-balanced, globally diversified portfolio will, over time, outperform the market as a whole with much less volatility and risk.

Bonds Still Valid In a Diversified Portfolio

We build diversified portfolios for our clients based on needs, goals (rate of return requirements) and risk tolerance. Right now, bonds still play a key role in portfolio construction primarily as a buffer against volatility. This is especially true for high-quality bonds such as corporate and short-term Treasuries. Historically, this philosophy has proven to be successful.

Bonds as a money-making investment have lost some of their luster. With rates so low, yields on most bonds are not very attractive (unless you are willing and able to assume an undue amount of risk). That said bonds have consistently had positive returns through the years. It really boils down to where interest rates are.

But rising interest rates—a common current prediction among pundits—don’t necessarily mean that bonds are suddenly going to tank. Historically, bonds have offered decent returns despite periods of rising interest rates. This also holds true for periods of high inflation even though inflation typically eats away at investment returns.

Clearly, the demise of the bond market due to rising interest rates or high inflation is greatly exaggerated. One of the main reasons for the resilience of bonds is that investors tend to flock to them during periods of uncertainty.

Current Investment Climate

Most U.S. stock indexes (S&P, Dow, etc.) have hit highs not seen since 2007. That’s quite a run from the markets depths of 2009 when most people believed the world was coming to an end. Does this mean the bears have gone? There is certainly a return of the mom and pop investors as money “rotates” out of cash into stocks. This often signals a market peak.

What do we mean by “rotation?” In the media, pundits use the term to describe movement of money from one asset class to another. They often say things like, “people are underinvested in stock”, or “overinvested in bonds.” In reality, there are a finite number of stocks (with the exception of IPOs and other new issues) so the stock shares and cash simply change hands, without necessarily increasing the aggregate amount of either.

The same is true for bonds, especially U.S. Treasuries. Every time the Treasury issues new bonds, investors buy them up, but it doesn’t mean they are rotating out of stocks. It certainly doesn’t mean new cash is coming into the market. The cash and stock positions simple change hands. After all, the market is simply an aggregate level of stocks, bonds and cash.

The cash amount in the market isn’t changing. Margin (borrowing money to purchase securities) can cause distortions in the amount of cash, but the aggregate amount of cash doesn’t really go up or down, it just changes hands.

People are entering the market because it’s going up, not because the fundamentals are good. This is another reason that you need an investment plan that takes emotion out of investing. For example, if you just inherited $1 million, it isn’t a good idea to jump into the market. You need to create an allocation that provides diversity and makes sense within the context of your investment plan.

Levelling Peaks and Valleys

We learned many valuable lessons during this period. First, we learned that diversification works. By allocating to REITs, gold and U.S. equities, our portfolios performed well. (We also got out of Europe for the most part as their economic problems started to heat up.)

So far, 2012 has been an eventful year for U.S. markets. The first quarter was the best performer for U.S. equities since 1998, but Europe was much lower.

That reversed during the second quarter, but by maintaining our global diversification, we were able to take advantage of the situation.

Lessons Learned from the Crash of 2007

Since the Crash of 2007, the investing landscape has changed dramatically. Hopefully, we’ve all learned lessons since the market peak of October 9, 2007 (it’s been a pretty wild ride since then). Within a year of October 10, most major indices had lost over 30 percent and would ultimately lose over 54 percent.

Many valuable investing lessons were learned from the Crash and we took many of them to heart. Most valuable is finding an investment style that is comfortable for you and sticking with it. Many investors learned the hard way that timing the market is a fool’s errand.

 

Defining and Finding Diversification

-David defines diversification and reveals where to find it, all within the context of today’s challenging investment climate.

Emphasis on Allocation

David reviews asset allocation within his clients’ portfolios.

Will Ben Bernanke Do the Twist?

David explains Operation Twist and why it doesn’t pay to worry about the latest Fed “dance craze.”

S&P Actions Shouldn’t Affect Your Long-Term Plan

-David takes a look at the recent downgrade of Treasuries by S&P, historical returns on the S&P, and why neither should affect your long-term investment plan.

Adjust, Don’t Abandon, Your Investment Philosophy

David explains why now is not the time to radically change your investment philosophy or plan.

Debt Ceiling, Downgrade and Default

By David L. Blain, CFA

If you read, listen to, or watch the mainstream media, you get the impression that 1) not raising the debt ceiling, 2) a possible U.S.default on its obligations, and 3) the downgrade of U.S. Treasury securities are creating a perfect financial storm that will bring the U.S.economy to its knees. Although these three issues are related, they are very different with distinct consequences and solutions.

The most damaging issue of the three, default on the debt is extremely unlikely; the government has billions of dollars coming into the Treasury every month to meet its obligations and can use these funds to make bondholder interest and principal payments. The U.S. Government’s problem is not a revenue problem, it’s a spending problem. Something would have to be cut if the government runs out of money, but an actual default on the debt is highly unlikely.

A downgrade of the debt by one or more of the leading ratings agencies (Fitch, Moody’s and S&P) is a very real possibility whether the debt ceiling is raised or not.  Although certainly not a desirable outcome, it need not be catastrophic. For long-term implications look at Japan—its debt was downgraded to AA in 2002, and then downgraded again in January of 2011 to AA-. The Japanese economy, although not as strong as it once was, has not collapsed. The people there still eat and function as a developed society and the Yen is still one of the world’s reserve currencies. A downgrade to AA is a long way from a CCC rating like Greece.

Even if the rating was cut U.S. Treasuries would still be the preferred currency for many domestic and foreign investors. Why? $13.4 trillion worth of Treasuries are held domestically and those investors would most likely opt to keep their investments at home. A mass liquidation by foreign holders—primarily central banks—would adversely affect the value of their remaining bond holdings, so it would be very foolish of them to start panic selling. Given the global economic situation, no other world currency offers the stability or liquidity of U.S. Treasuries; there just aren’t any other alternatives at this point.

As far as the long term investor  is concerned, there are actually many positive things going on in the financial world. First, corporations, U.S. included, are some of the strongest institutions in the world (Apple has enough cash in the bank to practically solve the Greece crisis itself). Also, manufacturing and industrial companies worldwide, once again U.S. included, have been expanding quite well the past two years. Additionally retail sales continue to trend upwards, defying expectations. Finally, despite higher food and gas prices, true inflation (defined as a broad systemic rise in the price level of an economy) remains low. All these are at least somewhat positive even for the most pessimistic souls.

We believe Democrats and Republicans understand the negative short-term consequences of not raising the debt ceiling and that some sort of deal will be struck. What kind of long-term plan they come up with to fully address the economic issues facing the country is anybody’s guess. But a default on U.S. Treasury debt remains unlikely as does a catastrophic ratings downgrade. And, despite its sluggishness, the United States has a resilient, broad-based economy that will continue to grow.

We remain vigilant and in tune with the changing situation but simply don’t feel the need to panic. As I have said many times through the years, all of the employees of D.L. Blain & Co. and their families are invested in exactly the same things as clients. I am personally adding funds to my account this week so that I can purchase more stocks if investors start to panic.

The situation in which we find ourselves today illustrates perfectly why we construct global, broadly diversified portfolios for you, our clients. Please don’t hesitate to call or email if you would like to discuss this further.

Be P/E -Wise When Investing

David explains the price to earnings ratio and how it relates to investing “with a margin of safety.” He also talks about a margin of safety in the bond market.

Will Currencies Put Money in Your Pocket?

David describes the global currency market and evaluates currencies’s value as an investment vehicle. He also answers viewer questions.

Questions from Viewers: Bond Bubble and Financial Regulation

David wraps up his discussion on bonds and investing then answers questions from viewers on the bond bubble and financial requlation.