21 Jun 2013 Removing the Bandage

How we hate the idea of removing a bandage. It so nicely covers the damage and the pain underneath that we soon prefer the façade to the reality. We especially fear its removal as we know the adhesive will only reluctantly and painfully give up its sticky hold on our very sensitive skin. Knowing the quick yank is best, we often resort to the painfully slow tugging approach.

Ben Bernanke, Chairman of the Federal Reserve roiled nearly every asset market Wednesday and yesterday following his explanation of how he expected to begin removing one of the most accommodative monetary policies in the Fed’s history. He said the Fed will probably begin tapering their $85 billion in monthly bond buying later in 2013 and halt purchases around mid-2014 as long as the world’s largest economy performs in line with their projections.

The third round of quantitative easing (QE3) began in September with the buying of $40 billion a month of mortgage-backed securities. In December the Fed added $45 billion of Treasury purchases to the mix saying they would continue until they saw substantial improvement in jobs. Members of the Fed expect the economy to grow between 3 and 3.5% next year driving the unemployment rate down from today’s 7.6% to between 6.5% and 6.8%. In other words, the Fed believes their regimen has done all it can to strengthen the patient and they will begin unwinding the supporting bandages and encourage the patient to walk then run on its own. Keeping the regimen in place too much longer would become counterproductive in their view.

So if the Fed seems confident enough in the economy’s strength to begin removing its life-giving and healing support, why did virtually every asset class drop like a rock at the mere mention of tapering support? Forget all the economic mumbo jumbo, the answer, in my opinion in human nature. Traders and investors have become accustomed to the comforts of anesthesia and being waited on by a doting Federal Reserve. Every economic complication in the past few years that rises to any significance at all has been quickly soothed by our ever-vigilant fast-acting Central Bank. The thought having to face an uncertain economy largely without the Fed’s support was too big a shock for some.

Yesterday’s synchronous dive across almost all asset classes suggests that it was the “fast money” guys – the hedge funds and the program traders who left the party, not the smart money. Given a relative dearth of traditional investment ideas in this risk averse climate, those who promise big returns are forced to devise increasingly esoteric schemes to generate outsized gains. The unusual volume of selling across almost all asset classes suggests that a significant percentage of fast money schemes in place Wednesday morning were no longer feasible or justifiable without the unusually accommodative policies of the Fed. Haven’t we marveled for months how the stock market can continue to rise despite a struggling global economy?

Stocks as measured by the Total US Market Index are down 3% for the week and 7.3% since their peak in May. But they remain up 12.1% year to date and 20.8% for the last 12 months. Our hedge assets, the 7-10-year US Treasury is down 1.8% for the week and down 5.5% since its May peak. It is down 2.8% for the past 12 months.

Other major asset classes joined the rout on Wednesday and Thursday as illustrated below by Dave Loeper, CEO of Wealthcare Capital. Click on the image to view interactively. These are prices alone and do not include dividend and interest reinvestment.

As stated before, VTI, or the Vanguard Total Market (US) Index, is still up over 20%. Foreign Stocks as represented by the VEU are up about 13%, Gold (IAU) is down over 15%, Treasuries (IEF) and Aggregate Bonds (AGG) are down about
4 and 3% respectively. High Yield (JNK) and Real Estate (IYR) fell between
quality bonds and stocks in the +2% to + 6% range.

This morning it appears that reason is being restored. Stocks are moving higher as US Treasuries are trending down. It is to be expected that Treasuries will remain under selling pressure as the Fed slows its price-supporting purchases. While the program will take years to unwind, we should slowly begin to see Treasuries return to their normal price movements which typically run counter to those of stocks.

Now that the Fed has warned that their program of buying Mortgage-backed bonds and Treasuries will wane in the coming months it is reasonable to expect renewed calls to dump Treasuries to avoid the losses. Unfortunately, the sellers’ logic might sound more plausible than it really is. Many have been calling for the demise or Treasuries for the past five years, but they were wrong as Treasuries have only gone higher. Now that Treasuries are near all-time highs the only place they can go is down right?

Bonds in general trade largely on expectations of future inflation and of the ability of the borrower to repay. Repayment of US Treasuries is not realistically in question, they are in effect exempt from these concerns.

Treasuries are also unique in that they provide a store of value that no other bond can claim – the full faith and credit of the United States of America. They are the most liquid, most recognizable, continually traded, universally available asset on the planet. Denominated in the world’s trading currency, the US dollar, they also represent an earning store of trading value for virtually any transaction anywhere any time.

But more important than any of the above, Treasuries represent like no other asset, a store of confidence when uncertainty reins. No other asset class provides a better hedge against stock market declines than US Treasuries. Extensive research by Wealthcare Capital has found that Treasuries maturing within 7-10 years have provided the very best portfolio protection when weighed against their potential for loss when conditions move against them.

Given that that the 7-10 year Treasury has never suffered more than a 9% decline over any 12-month period in the last 85 years and never back-to-back 12-month losses, Treasuries provide an inexpensive hedge against stock market losses that can be two, three or four times larger than their potential downside risk. Does it really make sense to reduce or remove cheap and proven effective insurance based on a hunch about the future?

What’s more, any losses you might avoid by selling declining Treasuries might be swamped by declining stocks with just a single outlier like say the European Union collapsing or Israel launching a military incursion into Iran. Without the offsetting hedging security of Treasuries in place, your portfolio would be exposed to the full weight of selling like we saw yesterday.

The portfolio you own is carefully and integrally designed to weather the toughest of storms. Each model’s component of cash, Treasury, Domestic, and International is precisely allocated to optimize its efficiency for return relative to its risk. On top of the most efficient portfolio available is our continuing stress testing of your plan which ensures that you will meet or exceed every goal you value.

The combination means that you do not need to worry about days like yesterday. Much worse than we have seen in the past six years has already been baked into our process. You can rest assured that we will contact you with new advice if we find that confidence has fallen below our range of comfort.

Have a great weekend.