2nd Qtr Portfolio & Market Observations 2012

While many people believe this is a very challenging time for equity investors they underestimate the environment for bond investors. Many of our clients use their investment portfolio to supplement other sources of income to pay for their everyday expenses while others rely solely on their investment portfolio. With historically low interest rates, relying on safe, secure high quality bonds to provide the necessary income is almost impossible.

As we stated in our commentary, the yields on 10-year U.S. Treasury bonds are at all time lows. Although a positive for mortgages as well as consumer and business purchases, it does little to provide for those needing income to supplement their living expenses.

Currently 10-year Treasury bonds yield 1.5%, which means for every $1000 invested you would receive $15 per year in interest. In July of 2007 bonds of the same maturity were yielding approximately 5%, generating $50 for every $1000 invested. To say this is a difficult environment to procure income is an understatement, and supply/demand issues only exacerbate the problem. Remember, yields have been on a downward trajectory since 2007.

We can’t control interest rates, but we can use other investments to increase portfolio returns. In the current environment equities look very attractive compared to bonds. The dividend yield on the S&P 500 is 2.1%, which is higher than the yield on a 10-year Treasury bond. In addition to increased dividends, each year investors have the potential for growth in the stock price. As we said in the commentary, dividends for the S&P 500 have grown at a 5.4% annual rate over the past 51 years. Unlike stocks, the income from a bond remains the same throughout the holding period, and at maturity you get back your original principal, and most likely less buying power.

Another tactic is to buy higher-yielding securities such as lower rated bonds or MLP’s, which invest in oil and gas pipeline and pipeline related securities. Investments such as these will increase income to a 6%-8% level; however they are riskier than government or high quality investment grade bonds. The key to any well structured portfolio is asset allocation and controlling risk. Because the yield levels are much higher than the bonds, we don’t need to invest the same amount to achieve a higher yield. For example:

$25,000 10-year Treasury bonds at 1.5% = $375
$5,000 in higher-yielding securities at 7.5% = $375

Were we to invest $10,000 in securities yielding 7.5%, we would generate $750 in income, allowing us to double the amount of income while only placing $10,000 at risk. To offset the risk of higher volatility we would set aside the remaining $15,000 in cash. True, the cash doesn’t earn much, but it is secure and doesn’t fluctuate in value. So what did we accomplish? We took $25,000 and only invested $10,000, but doubled our yield. Can this security be more volatile than the Treasury? The answer is yes, which is why we left $15,000 in cash to offset that risk.

These are the times we live in, and our job as your investment advisor is to adapt and prudently invest accordingly. Will rates go higher in the near future? Who knows? The Fed does not seem to think so. They have stated that they see rates staying at current levels through 2014. Is there inflation on the horizon? Again, nothing appears to say so. The point is, no matter what happens with interest rates, inflation or the markets, our job is to be able to best navigate and do what is most prudent for clients. We understand the frustrations and needs for income, but we also know that buying longer maturity bonds to increase the yield slightly over cash is not the answer. Keeping higher than normal cash positions, we feel, is the best option for many of our clients.

When considering the equity portion of the portfolio, to capitalize on the turbulence in the market, some excess cash allows us to take advantage of market dips. Markets never move straight up and having cash to buy on price declines helps improve portfolio returns. We appear to be in a trading range and believe this could continue for some time, so we are taking partial profits on expensive stocks and looking for new opportunities.

Market Commentary

Political turmoil across Europe, especially in the month of May, sent the broad-based S&P 500 index down -2.75% in the second quarter of 2012. The decline involved all sectors of the U.S. economy with the exception of the more defensive utilities and healthcare sectors, which managed to stay positive. The Nasdaq Composite Index, an indicator of the performance of growth companies, and the Russell 2000, which measures the performance of smaller companies, showed even deeper declines, losing -4.76% and -3.47% respectively. Foreign markets suffered even greater declines with the MSCI EAFA index down -6.8%.

Despite a poor second quarter performance the broad markets, as measured by the S&P 500 and the Dow Jones Industrials, are still up +9.49% and +6.83% for the six months ending June 30, 2012.

Continued pressure on some European governments has caused investors to look for safer investments in U.S. government securities. The yield on the 10 year U.S. Treasury bond hit an all-time low in June, with yields bottoming out at 1.47%. During the same period, the U.S. dollar has seen strong gains against the euro, with the exchange rates from euros to dollars reaching two-year lows.

The U.S. economy started slowing significantly in March after ending 2011 with a surge of growth and adding jobs at a solid pace in January and February of 2012. Consumer spending and industrial output was flat and orders sank for big-ticket durable goods (those lasting 3 years or more), a signal of waning business investment. Though most of those measures improved in April, the news in May turned negative, especially the report that job creation slowed again for the third month in a row.

The optimistic mood for the recovering housing market was dampened by news that builders broke ground on significantly fewer homes last month. While housing starts remain well below historical and demographic norms, there are indicators showing year-over-year gains, or at the very least, improving trends. The most obvious but not most easily attainable prop to any housing recovery are the historically low interest rates we are experiencing now.

Whatever the reason, the fact is oil prices have declined. Price of WTI crude went down by about $30 per barrel. Prices dropped from $110 in March to under $80 per barrel recently. Gasoline prices have mirrored oil’s fall, dropping about 60 cents per gallon. Whether oil prices remain at these levels remains to be seen, but if they do, that would give a needed boost to the U.S. economy.

During its last meeting, the Federal Reserve acknowledged the downshift in the U.S. economic growth and extended “Operation Twist”, initially scheduled to expire June 2012, through the end of the year. The move was an attempt to further push down long-term interest rates and thereby boost the economy by selling short-term government bonds and buying long-dated ones. In addition, the uncertainty about Washington, D.C.’s plans to address the nation’s fiscal problems and the so-called “fiscal cliff” at the end of the year – the expiration of the George W. Bush era tax breaks combined with deep automatic spending cuts – also looms over the recovery.

Our Outlook

Despite some volatile churning thus far in 2012, the S&P is still double where it was in the spring of 2009 and up +9.49% for the year to date. And, albeit an economic recovery is coming slower than we might like, the fact is the U.S. is recovering. Economic growth has been realized in twelve straight quarters. Unlike much of Europe, corporate America has deleveraged and its balance sheets have dramatically improved. If you look at the books of non-financial companies in the S&P 500, they currently have over $1 trillion of cash and short term investments against $2.6 trillion of long-term debt.

Looking at stock valuations we see current price/earnings ratios below historical averages. With dividend yields on the S&P 500 30% higher than the 10 year Treasury bond, it can be said that stocks, relative to bonds, look very attractive. S&P dividends grew 12.5% in 2011 and are expected to increase at a high single digit rate in 2012. Over the past 51 years, dividends have grown at a 5.4% annual rate surpassing the inflation rate of 4.1% annually.

The recent drop in crude oil and gasoline prices is a benefit to consumers but the U.S. economy is also getting a boost from our drive toward energy independence. Although controversial, new extraction technologies are making available vast fields of shale gas and oil. Not only is this giving U.S. manufacturers a competitive advantage in the global economy but the U.S. is now a net exporter of energy.

The U.S. economy is forecast to expand 2.2% this year and 2.4% in 2013. Should our economy slow even more, surely those estimates will be revised but right now the U.S. market appears to be the best investment opportunity available. Unlike Germany, the U.S.’s dependence on exports to GDP is a much lower percentage. While many countries depend on exports to grow it is not as critical in the U.S., our economy is more self-sustaining.

Are we looking for Congress and the President to tackle and solve any real problems between now and the election? Probably not, but the business of doing business will continue. American companies and consumers still need and buy goods and services and will continue to need and buy them. Yes, unemployment is still high and politicians are still dragging their heels, but we have never had any presidential election derail our economy. The one certainty that all of us are on the same page is that the economy must grow. That is what keeps politicians in office, what creates employers who hire employees and is the one aspect we ALL have the same interest in preserving.

Dumont & Blake Investment Advisors, LLC
June 30, 2012

Site by ThreeBears.com, Princeton