Newsletter Edition - January 2011


The Risk Trade and the Fear Trade

2010 turned out to be a year of positive returns across most asset classes, with U.S stocks earning 15%, U.S. bonds and hedged investments earning 4-6%, foreign stocks earning 7-8%, and emerging market stocks gaining 16%.
During 2010, unemployment remained high, the residential real estate recovery faltered, the economy barely grew, our national debt reached a record level relative to Gross Domestic Product, and a few municipalities and European countries almost went bankrupt.  So a good question is, “how does that environment translate into a 15% return in the stock market?” The short answer is that economic stability helped stocks a little, and the government helped stocks a lot. 
In the first part of the year, the economy was showing some signs of life, but quickly lost steam in the 2nd Quarter. The stock market responded to the declining economic indicators and the crisis in Greece, and lost 11% in the Quarter.  
In August, the Federal Reserve announced its intention to stimulate the economy by purchasing Treasury bonds (ultimately the plan is $600 billion).   Without going in to a long history of the relationship between Federal Reserve actions and the stock market, let’s just say this was a big deal. When the Federal Reserve lowers interest rates to 0, and then announces its intention to put more money in the economy by buying $600 billion of Treasury bonds, they are trying to push stock prices up. 
When the government buys its own bonds, the price of the bonds goes up and the interest rate goes down. Investors can’t earn a decent yield on bonds so they sell them in favor of riskier assets. By September, what we call the “risk trade” was on, and the end result was a 12% stock market rally in September and October. In December, Congress extended the Bush tax cuts and threw in an unexpected 2% reduction in Social Security payroll taxes, and the risk trade continued.   Basically, the entire 15% return in the market came in September, October and December, and most of that return was caused by government activity.  
To be fair, steady jobless claims, consumer demand and stronger corporate balance sheets may have helped a little, but smart minds agree that the government stimulus was a primary driver of investors buying stocks and other riskier assets. How long will the risk trade last? We have no idea, as that cannot be predicted. At some point the government stimulus will stop, central banks will raise interest rates, and both stocks and bonds will decline for a period.  It’s inevitable, but the timing is uncertain. Bullish sentiment is near an all time high, which is one strong indicator of a possible correction.     
So what are the lessons learned, and what should investors do now? The first lesson is to expect the continuation of volatility, or to expect the frequent back and forth between the “risk trade” and the “fear trade.”    Since the Lehman Brothers climax to the financial crisis in October of 2008, there have been 8 months in which the market went up 5% or more, and 7 months in which the market when down 5% or more. That is the majority, or 15 out of 27 months.   And the down months of -5% or more are not so far in the past, as three of them were May, June and August of 2010. This is the “fear trade,” as riskier assets are sold and investors flee to cash and bonds. We live in a superfast world. If the economy doesn’t improve without government stimulus, if a municipality defaults on some bonds, if we have another wave of foreclosures, or if a European country has another debt crisis, the fear trade will quickly replace the risk trade. 
Our strategy as investors is to “truncate the tails” or lower the volatility.  We intentionally reduce the number of months with 5% positive and negative swings. We are willing to give up something in the up months to stay away from the harsh down months. Our chances of compounding long term wealth and meeting client goals are greater if we avoid the harsh down months. 
If the economy does improve, interest rates may rise and bond prices may decline. We experienced this in the last recovery during 2004-2007. We are responding to this possibility by introducing some bond managers into the portfolios that have both the ability to sell bonds short as well as hold cash. These tactics can mitigate declines in your bond portfolio and present opportunities to buy bonds as they become cheaper.  Some commentators have suggested that investors hold no bonds.  We disagree. Bonds or cash are required as ballast or insurance for the portfolio if a crisis occurs. 
Hedged investments and active trading strategies trailed the stock market by a wide margin during the 4th Quarter. During any given quarter or year, investors should expect this to be the case, as hedged investments are uncorrelated to the stock market. For example, during the 2nd Quarter, the stock market dropped 11% and hedged investments declined only 2%. These strategies have demonstrated an ability to provide stock market returns with lower volatility over the long term. We believe these positive results will continue when measured over the long term, and we have made no plans to change our allocation to hedged investments for 2011. 
One of the changes we made to the portfolios in the last two years is to primarily use Dimensional Fund Advisors (“DFA”) core funds to buy stocks. The results have been positive. Below is a comparison of the 2010 performance of the three DFA core funds and the corresponding exchange traded index fund:
DFA Core Fund
Index Fund
Russell 3000 Index Fund
DFA Int’l Core
MSCI EAFE Index Fund
DFA Emerging Markets Core
MSCI Emerging Markets Index Fund
To give you a quick reminder, DFA is one of the largest mutual fund companies in the world, and they only work with institutional investors. The Board of Directors contains multiple Nobel Prize winners in finance. The core funds are low cost and tax efficient, and the funds are able to outperform index funds and exchange traded funds without using a concentrated portfolio.  Not only did the funds outperform in 2010, but have done so for more than 10 years. 
We wish you all the best in 2011, and feel free to call us with any questions regarding this report.
The Wagner Wealth Team

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