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Quarterly Letter to Clients

July, 2013

Indices at quarter-end (June 30, 2013):

Dow Jones Industrials: 14,909.60 2Q'13 +2.27% YTD +13.78%

Standard & Poor's 500: 1,606.28 2Q'13 +2.36% YTD +12.63%

In a recent cartoon a man opens a letter and says to his wife, “It’s a tax refund. There’s a note attached asking us not to cash it until next week.”

But enough of levity: The Fed has hinted that they might allow interest rates to rise and stock and bond markets have panicked. While higher interest rates will certainly have implications for stocks, bonds, and the general economy, we all knew that a rise was an inevitability. I would point out that the rationale for higher rates is a positive one: an economic recovery; and I, for one, am fairly confident that the Fed will not damage that recovery.

The first five months of the year were marvelous for stocks, while the bond market basically flatlined over that period. (What could one expect, what with rates that have hovered near zero for the last couple of years?) But then came that hint from the Fed and the reverie was shattered. Both stocks and bonds tumbled. By the time we hit bottom near the end of the quarter, over six percentage points had been shaved off the Dow Industrials. The major bond indices lost “only” around 3.5% in those last few weeks, though long-dated paper fell more than 10%.

Before that, bonds had trended slightly lower for the first two quarters. Stocks were able to end the quarter in plus territory, notwithstanding the messy ending of the period, and the major stock indices remain double-digit positive for the year-to-date.

I have been purposely allowing cash to build up in both my stock and bond accounts as the market has risen. Some people get itchy when cash builds in their investment accounts, but that itch miraculously disappears when the market tumbles. When, over just a couple of weeks, you see a thousand points lopped off the recent all-time highs, it becomes clear that cash is a legitimate investment option. While stocks mounted a quick recovery, regaining 500 Dow points in just a handful of days, doubt has certainly crept into the market and remains there. I confess that I like to buy on sale, and after that thousand point drop I did find a few stocks to nibble on.

In bonds, however, there is very little doubt: it seems to be consensus that the carnage is not over just yet. I continue to defer new bond purchases.

In a physics class the professor asks “Which falls faster, a pound of bricks or a pound of paper?” An economics student in the class asks, “Is it 30-year paper?”

Long-dated bonds (the previously mentioned 30-year paper) have fallen faster and farther than shorter paper, as would be expected. That is why I have emphasized shorter maturities for the last several years. Still, we get hurt when rates rise. In times like these, bondholders must remember to focus on the income and not the market value. To paraphrase John Bogle, it doesn’t matter what happens to the market value of your securities as long as the income (dividends and interest) keeps coming in. It is, however, a very rare investor indeed who is capable of ignoring sharp declines in his account value.

In our bond allocations we are as well prepared to weather the potential upheaval as is possible. This is a long-term game, in which you must correctly allocate your funds while suffering through the inevitable periods of pain. Patience and logic will produce a winning result over time. Remember that rising markets are the norm over the long term, and that declining markets may be swift, sharp, and painful, but they tend to be of much shorter duration. Such markets also often present us with opportunity.

Jim Pappas