Have We Separated From Reality?

The month of June was a good one. The S&P 500 was up over 6% for the month, but essentially just took back most of what it lost in the month of May (May was down over 8%). What we are seeing is the constant daily battle between bad news (unemployment, political battles, Fed actions, low GDP numbers, historically low interest rates, European meltdown, etc.) and good news (unemployment, political battles, Fed actions, historically low interest rates, European resolution?, etc.). Do you see the point I am making? Sometimes the same issues fall on both sides of the fence – often on the same day, and it creates this untethered whipsaw in the markets (known as volatility). Not a day goes by when we don’t read competing opinions (disguised as “expert” guidance from financial journalists with no real experience in finance) on the state of the market and its future.

The fact is, on a historical basis, we are still thickly settled amongst some of the most negative conditions the market has experienced in the past 100 years. This is not to say that recession and/or a significant market fall is inevitable. However, I DO feel that this is the likely outcome. As we have talked about in the past, the economy can only overcome so many obstacles before it succumbs to overwhelming pressure. In the current case, I believe we are closing in on that point. Last week we witnessed the Federal Reserve announce further activities related to Operation Twist (selling short term notes and buying-up long ones) in an attempt to further manipulate the yield curve (lowering long-term rates for things like mortgages). During their announcement, they hinted (strongly) that they still had the ability to take one more shot at quantitative easing (QE3), whereby they would re-establish a policy of buying assets from banks and injecting further liquidity into the economy. The problem with this whole concept is that this is essentially the last shot they have at actually turning things around. They are, essentially, out of any other options should this fail to provide adequate stimulation to the economy. It is the equivalent of storming the beach with your last rounds of ammo, hoping to take down the enemy.

What we saw with previous rounds of quantitative easing (QE1 and QE2), was successively less-effective results. And now that we are at the point of a zero-interest rate policy, and long-term rates the lowest they have been at any point in history, other than the few years following the end of WWII, rates have very little room to move any lower (thus the diminishing returns from successive rounds of easing).

Now the Reality Part

The market recovered nicely beginning in 2009, through early 2012, with a few significant stalls along the way (notably, the summers of 2010 and 2011). Much of this was driven by restored confidence, a slow but steady drop in unemployment, and economic activity (GDP) that was showing signs of life. However, those three metrics, typical measurements of economic health, have all turned considerably worse in recent months. Unemployment appears to have stalled around the low 8% range (8.2% at last count), GDP continues to be revised downwards, falling to anemic 1.9% in the first quarter of 2012, and Consumer Confidence is now at a 6 month low.

As we mentioned in our last commentary, government spending and stimulus has accounted for much of the growth and rebound over the past few years. Aside from a few pockets of investment here and there ( a warm winter helped construction in late 2011, as well as inventory buildup), government intervention has accounted for much of the growth. But again, with interest rates at near all-time lows, Fed intervention is no longer the shot in the arm that we have come to expect. It should be noted that we are now facing the only time in history when we have seen four straight quarters of sub-2% GDP growth and NOT been in a recession. This begs the question as to whether we have already entered another recession.

Impact on Portfolios

We continue to maintain very modest allocations to equities in light of current conditions (10-15%). For private client portfolios, allocations to income-producing investments make up the bulk of portfolios. This includes mortgage-backed securities (both US Government Agency as well as non-agency bonds), emerging-market bonds (for obvious reasons, we are not invested in bonds of most European nations), high-yield bonds, short-duration bonds, real estate, as well as small allocations to global equities.

For 401K model portfolios, we continue to maintain a conservative stance. Although many local 401K plans do not offer many of the alternative asset classes that we seek out to find relative value and income, it’s important that our allocations remain conservative in order to avoid potential abrupt downtrends in the market. As such, our most aggressive model portfolios for employee 401K plans remain at only 25% equities, one of the most conservative positions we have taken in several years.

Should conditions further deteriorate, we will consider further lowering our exposure to risk assets – both in our 401(K) plan model portfolios, as well as in our private client portfolios.

If you are an employee or retiree of General Dynamics, Pfizer, or L&M Hospital, and you would like advice and direction on managing your Fidelity 401K or Hewitt 401K plan, please sign up for our monthly newsletter, which provides complimentary ongoing advice, commentary, and model portfolios for each of those plans. You can sign up automatically at http://www.lwmwealth.com/services/your401k.html.

Robert C. Henderson is the President of Lansdowne Wealth Management in Mystic, CT. His firm specializes in financial planning and investment management for individuals approaching retirement or already in retirement, with an added focus on the particular needs of women that are divorced or widowed. He is an Accredited Asset Management Specialist and a Certified Divorce Financial Analyst. Mr. Henderson can be reached at 860-245-5078 or bhenderson@lwmwealth.com. You can also view his personal finance blog at http://lwmwealth.com/blog and the firm’s website at http://www.lwmwealth.com.