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Taper Tantrums

Posted on: October 15, 2013 |

Is This More of the Same?

If you recall, last quarter’s report had a line graph of your account(s) performance for the quarter.

The market started up in April and continued to advance until late May when Fed chairman Bernanke spoke about tapering. Then the markets plummeted until late June when Mr. Bernanke said he didn’t mean the possibility of tapering would occur that soon; the tepid taper! A robust rally quickly ensued. The quarterly performance chart was quite a zigzag. Probably caused a spike in blood pressure medication sales!

This quarter was more of the same. The Dow Jones 30 Industrial Averages moved over 3,000 points, yet eked out a gain of only one percent from July through September.

Beginning of 3rd quarter the Dow was: 14,974
August 2nd the Dow was: 15,658 a gain of 684 points or +4.56%
August 27th the Dow was: 14,776 a loss of 882 points or -5.63%
September 18th the Dow was: 15,676 a gain of 900 points or +6.09%
September 30th the Dow was: 15,129 a loss of 547 points or -3.48%

The Dow, as you see, moved in broad gyrations with little to show for itself when the quarter finally ended; a positive return of only 155 points or 1%.

In general, your accounts fared much better. The more aggressive accounts, those with a higher percentage allocation to equities, had handsome returns. The more conservative, mostly fixed income accounts also had decent, but modest, positive returns for the period. The key to the rate of return was the asset allocation based on your personal Investment Policy Statement.

The Dimensional Funds performances were stellar with small, micro, and some international funds having double digit gains. In the bond sector, even the short-term government portfolio squeezed in a small gain for the quarter, albeit still off slightly for the year. Enclosed, for your benefit, is an article about Dimensional that appeared in the August 5, 2013 Barron’s magazine.

Fixed Income

Fixed income investments include corporate and government bonds. Adding these asset classes to your portfolio has, for the past fifteen years, reduced overall risk and provided a positive contribution to returns. For several years during that period the only upside came from bonds. The Barclays U.S. Aggregate Bond Fund was adding nearly 5% on an annualized basis. This abruptly changed in April and May when the Fed signaled they were going to start “tapering”.

The Federal Reserve, since the financial crisis of 2008-2009, has created or invented new ways to stimulate the economy. Recall that unemployment was near 10% and rising, home foreclosures were soaring, banks and financial institutions were failing and the international goriness of a multi-country fiscal collapse weighed heavily on an already shaky worldwide economy.

What we, and other central banks, did was lower interest rates to near zero. Our Federal Reserve made monthly ($85 billion) market purchases of U.S. Treasuries and mortgage backed securities. This $85 billion printing machine kept interest rates falling, unemployment started to decline, institutions began recovering, and the European fiscal crisis was put on the back burner. Reducing the monthly Fed purchases is known as “tapering”. In other words, the Fed was saying the days of easy money are going to start winding down.

Inflation has remained somewhat tame, as the recovery has been quite gradual. One reason for such tameness is that, unlike previous recoveries, this one has not been all encompassing or deemed to “float all boats”.

Our clients, for example, are probably in the top 10% or higher of both net worth and income. In general they, and others like them, have not only recovered from the financial debacle of six years ago but have prospered. Others have not recovered, and may be worse off than before the crisis began; losing homes, jobs, and savings.

So, What to Do?

Fixed income assets play an important part in the overall asset allocation. By adding bonds to our holdings we reduce our exposure to the historically riskier equity asset classes.

However, given the current environment, we intend to keep our bond maturities on the shorter side and steer away from long-term purchases. Your Investment Policy Statement (IPS) may have a range of allocations for equities and fixed income. For now, we are veering to the lower part of the allocation range for bonds.

Compliance

When Ferguson Asset Management was just a pup, compliance with Securities Laws was straight forward and spelled out in the Investment Advisers Act of 1940; do right, keep good and accurate records, and maintain copies of all client communications and orders. Through 2007, we were randomly audited five times; standard procedure for those of us in the Advisory business. Then along came the Bernie Madoff ($65 billion) and Allen Stanford frauds ($8 billion) and compliance changed big time. Now firms just a tad bigger than we are have full time compliance officers. We applaud these compliance trends, but new audit and record requirements are impacting start-ups, adding to merger trends, and contributing to increased advisor retirements. This isn’t a complaint, just a statement about what goes on behind the scenes.

The ADV II is a disclosure document about our business that we file with the SEC and is updated at least annually. This document is available at www.sec.gov or we will be pleased to send you one. The Annual Privacy Policy, which discloses how we treat information we have about you, is attached.

We emailed congratulations to Dr. Eugene Fama this morning, a director and guiding academic at Dimensional for being awarded the Nobel Prize in Economics today. He is considered “the father of modern finance” whose research has helped shape the way we design and manage portfolios.

John, Derek, Christina, and Jon extend our warmest greetings to you and for this holiday season.

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