GUEST COMMENTARY: Eye on Wall Street: Moving slowly in the right direction


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We are in the fifth year of an economic expansion (a bit long in the tooth considering history) and the economy still “feels” pretty sluggish. While the unemployment rate fell to 6.3 percent in April, job growth has been modest and economic growth has been about half of what it normally would be after a sharp recession like what we saw in 2008.

In fact, in the first quarter economic growth came in at an anemic 0.1 percent, while inflation climbed only 1.3 percent. Analysts blame the cold weather and predict 80 percent of lost output will likely be restored in the coming quarters. That sounds reasonable.

The silver lining here is very low levels of inflation and interest rates. That has proven a powerful elixir for the equity markets. Earnings have been decent and profit margins fat as productivity has improved and wage gains have been modest. Stocks were beaten up pretty badly during the panic of 2008 and have rallied 210 percent since the bear market lows of March 2009.

S&P 500 stocks have been range bound so far this year. They were up 0.7 percent in April and 2.6 percent year to date. The overseas equity markets have done slightly worse in 2014. Part of the sluggishness in stocks is uncertainty over the economy and geopolitical turmoil. But underlying it all is the fact that U.S. stocks aren’t cheap anymore. Fair value at best is how we would describe the market.

Are stocks an inflation hedge?

The short answer is yes. The Wall Street Journal notes that over the long haul, dividends have outpaced inflation. They opine: “Over the past 100 years, the dividends from a diversified collection of U.S. stocks would have grown at an average of 4.4 percent a year, easily outpacing the 3.2 percent average inflation rate.”

But wait, there’s more. That portfolio of stocks would have produced annual price gains of 5.6 percent as well. That plus the dividends gets you to a historical annualized return of 10 percent.

Those results are over the long run. Unfortunately choppy up and down markets over the short run can scare investors into selling low and buying high. The most recent DALBAR study, Quantitative Analysis of Investor Behavior, quantifies this phenomenon showing that investor’s returns lag the mutual funds that they buy. DALBAR calculates that the S&P 500 returned 9.2 percent over the past 20 years ending 2013, but the average equity fund investor earned only 5.0 percent.

Why have bond yields stayed low?

Bonds have defied expectations this year as interest rates fell and bond prices rallied. That is in sharp contrast to last year when the 10-year Treasury sold off from 1.6 percent in May to 3 percent at yearend. It is now back down to 2.6 percent at the end of April and has provided a total return of 4.3 percent year to date.

There are several explanations:

(1) Inflation has remained tame across the globe. Here in the U.S. it is well below the Federal Reserve’s target rate of 2 percent.

(2) Central banks have been very accommodative. In the U.S., the Federal Reserve is “tapering” its monthly bond purchases but tapering is not tightening. In Japan and Europe monetary authorities are more inclined to ease further than tighten. Japan has a deflation problem. Europe is flirting with deflation and has a 12 percent unemployment rate.

(3) There have been increased geopolitical risks owing to the Ukraine crisis. We have seen a flight to quality bid in the market.

(4) An improving U.S. budget deficit means there are fewer and fewer new Treasury bonds to buy!

(5) There are lots of funds to be invested chasing deals in the equity markets and yields in the bond markets.

I know we sound like a broken record. But, bonds are just not that attractive compared to the alternatives. Own them as ballast and insurance in diversified portfolios of course, but keep them a bit shorter than normal.

Jeff Pantages, CFA, is the chief investment officer for Alaska Permanent Capital Management, a $2.4 billion investment management and advisory firm located Anchorage.

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