News & Insights
A Change in the Weather
The stock and bond markets have recently enjoyed seven remarkably calm and productive months. This interregnum of smoothly rising stock markets and orderly bond markets was interrupted in late June when Dr. Bernanke and his cohorts at the Fed began to discuss in earnest the possibility of "tapering" their extraordinary $85 billion per month bond buying program or QE. Long term interest rates (as represented by the yield on the benchmark 10 year Treasury), which were as low as 1.7% in May, ended the month at over 2.5%. This quick 47% rise in rates triggered by the mere possibility that monetary policy will become less accommodative represents to us a preview of the changing environment investors will face in the coming months and quarters.
We believe stock market values have become stretched over the past few quarters, justifying a more defensive posture as the market moved into record price territory. The string of triple digit price swings during June heralds a significant change in the investment climate when open-ended monetary support is no longer assumed by market participants, and underscores the value of a cautious approach. Viewed from a long-term perspective, this change is necessary and welcome. Extraordinary policy from the central bank has to end and, if accompanied by an improving economy, is welcome. As investors reset expectations, the markets will be choppy.
More important than our recounting of recent events is what we are expecting for the future. Do we see significant downside for stock prices? Are longer-term bonds, once considered safe havens, destined to lose value as the economy turns and the Fed exits?
We claim no crystal ball but we continue to believe stock values are stretched, limiting future returns. This guides us to keep a conservative allocation to the market, but we do not recommend a dramatic (10% or more) reduction in stock market exposure. There is a dearth of quality assets and an abundance of savings around the world. As markets overseas have been roiled, global investors are likely to keep their allocation to high quality U.S. stock fairly high, providing support for today’s elevated levels. This is likely to at least partially offset the effect of higher interest rates.
While the bond market's increase in rates has been swift, we do not expect rates to climb sharply higher from these newly elevated levels. Certainly the long term rates will drift even higher over time, but that adjustment should be more orderly than June’s price action would suggest and there is a good chance we will see slightly lower rates, as the selling seems a bit overdone.
We are not Pollyannas. Given the extraordinary financial conditions that have existed since the financial crisis, we remain alert for signs that risks are increasing and would not hesitate to become even more defensive if conditions warrant.
The Altavista Investment Team – Summer 2013