Portfolio Newsletter 3Q 2015

As we reach the end of the second phase of the current market correction, I am pleased to report that all portfolios have outperformed the market (net of fees) as of September 30. This continued success is a result of diversification, sector selection and low fees.

The mid-year rebalance went smoothly and produced a successful outcome. We avoided the three worst performing sectors that declined at least 20% since mid-year: Materials, Energy and Metals. Even though our portfolios dropped from their highs, they did not lose anything close to that percentage due to minimal exposure to those sectors.

Our research and strategy are both working well.

Market Correction

The market is once again in correction mode following the Federal Reserve Open Market Committee’s (FOMC) decision in September to hold interest rates at zero. Since 1980, the market has experienced a correction of 5% to 33% in the six-month period preceding a decision by FOMC to raise interest rates. Based on recent market behavior, there is little question we are now in that six-month window.

Many people are seeking an explanation for this market correction, with China being one focus. It is important to understand while there are always external forces at play, the stock market is cyclical. Corrections are normal, healthy functions of a stock market and should be treated as such. It is worth noting the stock market recorded its third longest bull market, prior to the current correction.

Excluding the worst performing sectors of Materials, Energy and Metals, this correction has been relatively mild for the average investor. The S&P 500 is only down approximately 4% since mid-year.

Because we anticipated the inevitability of this correction, we were able to take steps to avoid the worst performing sectors and are doing quite well! It is really all a matter of perspective.

Zero Interest-Rate Policy

Following the FOMC decision to hold interest rates at zero, Chairman Yellen made it clear every meeting going forward will be a “live” meeting. Previously, when the FOMC did not schedule a press conference following their monthly meeting, the common belief was they could not announce a policy change. Going “live” means the FOMC can announce a policy change, whether or not a press conference is scheduled.

Since 2008, the FOMC has effectively maintained a zero-interest rate policy. It’s interesting to compare this to Japan, which has had a similar low-interest rate policy for 20 years. During this time, Japan’s economy has underperformed, had little or no inflation, and has experienced multiple recessions. The outlook of continuing down this same path is not encouraging.

Historically, the track record is poor for economies that maintain a low interest rate policy for extended periods of time. Conversely, we can look back at the U.S. economy during the 80s and 90s to see when interest rates were higher, the economy expanded and performed well.

Continuing down this path is dangerous. Members of the FOMC are well aware of this, as is much of Wall Street. This is the reason the market reentered a corrective phase following the FOMC’s decision to hold interest rates at zero.

I do expect the FOMC to move off the zero interest rate policy by the end of 2015. If not for the reasons above, then in early January when changes will take place with the Fed.

At the January 2016 meeting, four voting members are scheduled to be replaced. Two voting seats are currently open. This means six of the twelve voting seats could potentially change in January. It presents an excellent opportunity for those members on their way out to institute a policy change.

Our portfolios are largely aligned with the expectation the FOMC will raise interest rates this year. As opportunities present themselves, we will make adjustments to take full advantage of the rising rate market.

China

China has been getting some of the blame for this recent correction. Their stock market is also correcting due to their economy cooling off. The Chinese stock market, known as the SSE Composite, peaked on June 12, 2015. It had skyrocketed 151% since June 12, 2014. (That’s not a typo!)

The SSE Composite has dropped almost 40% since June 12, 2015. This is clearly a correction. Looking back during the year from June 12, 2014 to now, China’s market is still up 40% on an annualized basis. It is reasonable to believe the Chinese stock market is in a bubble. Put into perspective, this should come as no surprise that it has fallen from its meteoric rise.

With respect to our portfolios, there is minimal, yet reasonable exposure to China.

Opportunities / Risks

Banking Sector

The Banking sector is one of the top sectors on my list to add to the portfolios. It is an interest rate bullish sector. That means this sector performs well in a rising interest rate environment. In anticipation of the FOMC raising rates, Wall Street recently drove both interest rates and the Banking sector up.

Upon the announcement interest rates would remain at zero, the Banking sector sold off as interest rates dropped. Its recent performance supports my expectations of what will happen when interest rates do eventually rise.

At the appropriate time, I will add the Banking sector to the portfolios. This could coincide with either the FOMC raising interest rates, or interest rates dropping further to the lower bound of their range.

 Long-Term Bond (Senior Floating-Rate) Position

We replaced the long-term bond position with a Senior Floating-Rate bond fund at the end of 2013. Senior Floating-Rate funds invest in interest-rate sensitive debt, where the interest rate adjusts as interest rates rise and fall. In a rising rate market, interest rates adjust upward which can reduce the risk normally associated with a rising rate market. This does not mean these funds will appreciate in a rising rate market, or that they will not lose money in a rising rate market. It does mean they should have less risk than other bond funds.

This position has been a placeholder with the knowledge that long-term bond funds can quickly lose value going into a rising rate market. It has done its job. Long-term bond funds lost money this year, while floating- rate funds had a positive return with far less volatility.

The opportunity in this position is with hedged bond funds that have a negative duration. This means that unlike a traditional bond fund that loses value when interest rates go up, a negative-duration bond fund appreciates when interest rates go up. Historically, long-term rates start moving up approximately one month prior to the FOMC raising interest rates. The downside risk is minimal since it is unlikely interest rates will fall substantially at this point. The upside potential far outweighs the downside risk.

Effective immediately, new purchases to any portfolio with a senior floating-rate fund will be allocated to an inverse government long-term bond fund instead. Following the publication of this newsletter, existing portfolios will be reallocated from the senior floating-rate fund to an inverse government long-term bond fund.

High-Yield Bond Position

Currently, this position is invested in a low-duration high-yield bond fund, which due to its low duration focus, is well suited to mitigate the risks of a rising interest rate market. Like the hedged long-term bond funds, there are hedged, negative-duration, high-yield bond funds that appreciate in value as interest rates rise. Due to the larger yields of high-yield bonds compared to long-term bonds, we will make a positional change closer to when the FOMC raises interest rates.

Short-Term Bond Position

When short-term interest rates rise, the greatest risk is to short-term bond funds because they can quickly lose value. All short-term bond funds available on the Schwab platform require a 90-day hold. This means any immediate change to the current short-term bond fund would create a new 90-day hold. I am uncomfortable with this move.

Due to risk of potential losses from this position, my plan is to hold onto the existing short-term bond fund and monitor its performance as the FOMC raises rates. If necessary, the fund can be sold and the proceeds held in cash until a more suitable opportunity presents itself to reinvest in another (or similar) short-term bond fund.

Positional adjustments to the portfolios will be made this month in order to take advantage of current opportunities. I will keep in touch with you as changes occur.