Our Thoughts

Quarter In Review: Choppy Waters

“When feeling seasick due to rough waters, keep your eyes on the horizon” – good advice for passengers on an ocean liner and good advice for investors when volatility takes over the equity markets as it has done since late September.  But, first a few words about bonds….

Fixed Income.  The expected rise in U.S. interest rates failed to materialize in the third quarter, confounding the experts yet again.  At the long end of the yield curve, 30-year Treasuries were yielding 3.20% and 10-year Treasuries 2.50%.  At the short end, three-month T-bills were yielding a miniscule 0.02%; six-month bills were only slightly more generous at 0.04%. U.S. Fixed Income was up 0.17% for the quarter and 4.10% through September 30th.  International Fixed Income is up 2.08% for the quarter and 6.55% YTD.

This is news, but nothing compared to the headlines following Bill Gross’ departure from Pacific Investment Management Co.  Mr. Gross, founder and CIO, managed the Pimco Total Return Fund from its inception in 1987 until his abrupt resignation on September 26th.  FJY’s Investment Committee met that Friday morning and decided to liquidate (for discretionary clients) and recommend the sale of (for non-discretionary clients) all positions in Pimco Total Return, as well as all positions in Pimco Foreign.

This decision was not based on Pimco Total Return’s performance.  Although retail investors pay as much as 1.6% in annual expenses to invest in the Fund, FJY clients held the institutional share class where annual expenses are 0.46%.  The difference of 1.14% goes straight to the bottom line, i.e., returns will be higher for the institutional share class by approximately 1.14% per year.  This share class has outperformed the Barclays U.S. Aggregate Bond index by 2.41%, 0.95%, 1.37%, and 1.15% annually over the past three, five, ten, and fifteen years, respectively. Granted the Fund has lagged the benchmark by 0.67% over the past twelve months.  But it lagged in 2006, 2008 and 2011, then outperformed the benchmark in each of the following years by: 2.10% in 2007, 7.90% in 2009, and 6.15% in 2012!  Does that mean that FJY will soon be recommending the Janus Global Unconstrained Bond Fund that Mr. Gross now manages?  The short answer is “no”, at least not until the Janus fund has a track record of its own.

This decision did not reflect a lack of confidence in the team that now manages the Fund and has been working with Mr. Gross for years.  Daniel J. Ivascyn, Morningstar’s fixed income manager of the year in 2013, now oversees the Fund’s three-manager team, which includes Mark R. Kiesel, Morningstar’s fixed-income manager of the year in 2012.  Still it does take time for a new team to jell and, in the short run, redemptions are a concern.  In September $23.5 billion was withdrawn from Pimco, most in the final three trading days of the month.  It is possible that the pressure of redemptions could affect the Fund’s returns going forward.  If it acts upon concerns about redemptions, the three-manager team (and teams managing Pimco Foreign and other Pimco bond funds) could decide to hold more highly liquid investments such as Treasuries than they would choose to hold if they weren’t anticipating additional redemptions.  The Fund’s team could also find itself having to sell less liquid positions at a discount in order to meet redemptions.  So, in a nutshell, FJY decided that we wouldn’t subject our clients to the possibility of a bad outcome.

On behalf of the FJY investment committee, Laurie Belew sent an email to clients on Wednesday to share that the investment committee has approved the American Century Diversified Bond fund (ACBPS) as the core domestic fixed income holding for our clients.  We will act on our trading discretion when possible and will reach out for authorization to trade in non-discretionary portfolios. The process may take several weeks.

Equities.  Although real estate investment trusts (REITs) fell 2.48% for the quarter, the index is standing at a robust 13.36% gain for the first three quarters of the year!

Large U.S. company stocks were the market leaders over the past three months, but the gains were modest.  The widely-quoted S&P 500 index posted a gain of 1.13% for the quarter and is up 8.34% since January 1st (through September 30th).  Small U.S. company stocks as measured by the Russell 2000 index fell 7.36% in the third quarter – representing its worst quarter in three years – and is down 4.41% (through September 30th).

The rest of the world put a drag on diversified investment portfolios.  The broad-based EAFE index of companies in developed economies outside the U.S. fell 6.39% in dollar terms during the third quarter, and is down 3.63% through September 30th.  Smaller foreign company stocks dropped 7.20% for the quarter, and are down 7.23% through September 30th.  Commodities fell 11.83% this past quarter, and now sit at a loss of 5.59% for the year through September 30th.

Looking Ahead.  Since the end of September, the S&P 500 index has done something frequently that it normally does infrequently – moved more than a full percent up or down in a single day.  Consider the recent pattern this month:  down 1.3% on the 1st, up 1.1% on the 3rd, down 1.5% on the 7th, up 1.8% on the 8th, down 2.1% on the 9th, down 1.1% on the 10th, down 1.65% on the 13th, and up 1.29% today (Friday).

Slowing growth in Europe and China, political tensions in the Ukraine, ISIS, the Ebola epidemic, political unrest in Hong Kong….These are among the explanations for the recent stock market slump.  Nevertheless, the U.S. economy is still growing, albeit slowly, and corporate earnings are well-above historical averages.  Oil prices are at their lowest level since November 2012, consumer spending in the U.S. has rebounded, and although the Fed will cease its bond purchases this month, there is no indication that it is going to put its inventory back on the market.

Notwithstanding, pullbacks do not always reflect reality.  Selloffs are often lead by investor sentiment – in other words, human emotions and a crowd or herd mentality.  At present investors seem to be worried that stocks are overdue for a correction (a decline of at least 10%) and, if corrections operated on a schedule, they would be right.  We are in the fourth-longest bull market since 1928, and we haven’t experienced a correction since 2011.  The Conference Board reported that U.S. Consumer Confidence slipped dramatically, and unexpectedly, in September, lending some credibility to the surmise that the investing herd has been startled and their expectations appear to be creating market reality.

Does that mean we should take action?  Unfortunately, nobody knows whether the markets are poised to act on the good economic news and move up, or are ready for a selloff that would finally deliver that long-delayed correction.  History tells us that it is a fool’s game to try to anticipate market corrections, and that investors usually get rewarded for sailing through the choppy waters and focusing on the horizon, rather than jumping off the ship when the waves get high.

We cannot know in which direction the markets will experience their next 10%, 20% or 30% move.  But unless you believe the world is about to end, you do know, with some degree of certainty, in which direction it will make its next 100% move.  That’s the best prediction of the markets you are likely to get from FJY, even if it doesn’t come with a timetable!