Letter to Clients: 3rd Quarter 2014

Dear Clients and Friends:

You may have noticed that this quarter’s letter went out a bit later than usual. I was waiting until we had final confirmation. DV Financial will be moving before the first of October into a new office! Many of the details have yet to be finalized but the new office will be located at 2763 86th Street in Urbandale, just behind Panera Bread between Hickman Rd and Douglas Ave with convenient access to both I-235 and I-80. More information to follow…

The journey is not always smooth
It’s easy, relaxing, and even fun to drive on a smooth road. There are no bumps, just a quiet and uneventful ride. It’s those unexpected construction zones and traffic jams that sometimes tempt us to bail and seek a different route. In most cases, bailing adds unnecessary time to our travels and delays our arrival.

Last month we got a clearer picture of winter’s indelible stamp on the economy. We experienced a sharp 2.9% contraction in first-quarter gross domestic product, which is the broadest measure of goods and services in the economy. And Russia remains engaged in Ukraine. But in both cases, stocks brushed aside any jitters.

Oh, those emerging-market jitters? Shares in developing countries have rallied nicely.

It all comes back to our recurrent theme: Stick with the plan that’s been tailored to your desired outcome and willingness to take risk.

Let’s not forget that the carefully calibrated portfolio we’ve recommended anticipates some turbulence and pit stops on our journey. We don’t always know when we’ll hit a pothole or feel the need to pull into a rest stop, but we know it will eventually arise and have allowed for that in our plans.

We hit a few of those soft spots in the first quarter, but following a minor consolidation, most of the major market averages claimed new ground in the second quarter, rewarding those who patiently followed the roadmap we’ve developed together.

It’s not that we won’t make adjustments when conditions dictate, but it’s always important to keep the long-term goal in mind. If your situation has changed it is important that we meet to discuss any changes for your current plan.

The bull marches to new highs
3Q14 Client Letter ChartTo help explain the latest upward march in stocks, I think we have to take a step back and look at one of the key drivers of the rally over the last couple of years—the super easy monetary policies implemented by the global central banks. Whenever the conversation turns to monetary policy or the Federal Reserve, I sometimes get a look that says “I’d rather be watching the grass grow.” But please don’t skip this information, as it has an enormous influence on the direction of the market! Let me explain.

In his book Winning on Wall Street, the late great Marty Zweig, an influential and highly respected Wall Street icon, summed it up well:

The monetary climate—primarily the trend in interest rates and Federal Reserve policy—is the dominant factor in determining the stock market’s major direction.

One controversial tool the Fed has used to keep interest rates low has been Qualitative Easing, the purchase of longer-term Treasury bonds and mortgage-backed securities (bonds and yields move in opposite directions). During 2013 the Fed bought $85 billion in bonds each month with freshly minted money, but it has been cutting back at regular intervals. As of the Fed’s late June meeting, they were buying $35 billion per month and will probably cease purchases in the fall.

Right now the Fed says its current plan is to keep interest rates at rock-bottom levels for a “considerable” period of time. Even after the first increase, rate hikes are expected to be gradual.

It’s a plus for stocks, which don’t have the competition from the low rates of return on money markets, T-bills, and other safe fixed-income investments, but it punishes savers and encourages a “reach for yield” in riskier investments. Jeremy Siegel, a well-respected professor of finance at the Wharton School of Business and a market bull, offered his take in an early-July interview on CNBC:

Investors are looking for yield and want to go to dividend-paying stocks, which now are yielding 3%-4% and more, which is well above the Treasuries and well above the money markets. I think that’s going to be a steady flow of demand for the next several years from the public.

It’s the current level of low interest rates that argues for a bullish stance, according to Siegel, though he does see some risks to the outlook. Siegel says possible pitfalls that aren’t priced into the market include the potential for higher inflation. He believes that wage gains that aren’t matched by productivity increases, or much higher oil prices, could be a problem. Currently wage gains haven’t been very impressive for most folks, but oil has the potential to be an unwanted wild card.

David Tepper, who runs the $20 billion distressed debt hedge fund Appaloosa Management, is not a household name but he is a closely followed hedge fund manager that has one of the best long-term track records in the industry. In May, he had become a bit more cautious—not outright bearish, but no longer ready to jump headfirst into stocks. Since the European Central Bank’s June meeting some of his concerns have been alleviated.

Why Europe matters—a lot
The reduction in Fed cash flowing into the financial system seems to have slowed the bullish juggernaut during much of the first half of 2014. But as the Fed has been cutting back, a new kid in town has emerged—it’s called the European Central Bank (ECB). Like the Fed, it has the potential to create cash out of thin air and buy up debt.

Unlike the U.S., Europe is struggling with a rate of inflation that is too low. That doesn’t sound like a problem to most consumers, but Europe isn’t far from slipping into what is called “deflation,” or a general decline in the price level. Sure, it sounds enticing. Who wants to pay more when you can pay less? But in reality, most economists view deflation as an economic black hole.

With the exception of a few industries that have learned to manage declining prices (technology comes to mind), deflation may cause some consumers and businesses to delay purchases and further exacerbate economic weakness. A quick look at Japan’s experience over the last 20 years offers up a sobering example.

This matters because the ECB took modest unconventional measures at its June meeting. More importantly, central bankers in Europe continue to hint that they may begin a U.S.-style program of buying longer-term bonds, encouraging investors to jump into stocks throughout the month of June.

Keeping an eye on the U.S. economy
Job growth has accelerated markedly in recent months, yet economists are estimating that GDP stalled in the first half of 2014. I suspect that we may eventually see upward revisions to recent data that have been suggesting consumers are in no mood to spend.

I’m cautiously optimistic that recent jobs gains will power consumer spending in the second half of the year. But if growth does not accelerate, the Fed could hold interest rates at near zero for even longer than many anticipate.

Investor, know thyself
I am here to advise and assist as you travel on your financial journey. Yet I want to be careful that you do not take too much risk for your particular situation.

A number of variables go into the risk equation as we craft a portfolio for you that helps you meet your goals while not taking undo risk. We don’t want you to experience sleepless nights generated by market storm clouds. A balanced portfolio helps to manage risk.

Finally, it’s easier to stay committed to your plan when the market is moving higher. As I said earlier, it’s those bumps in the road that sometimes encourage us to take unplanned detours. In hindsight, these usually lead to backtracking and lost valuable time. So let’s stay on track.

I hope you’ve found this review to be both educational and helpful. If you have any questions or would like to have a personal discussion, I would like to meet with you. As always, I am honored and humbled that you have entrusted me with your finances. I truly appreciate the opportunity to help you realize your financial goals.

Sincerely,

Art Dinkin, CFP®