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End of an Era

Posted:October 11, 2014


Paul Hancock, CFP®    October 11, 2014


“An era is ending: for over half a decade, nearly worldwide, zero interest rates suppressed volatilities. That is over. More and exciting volatilities lie ahead.” – David Kotok, October 5, 2014


The third quarter ended eventfully with a resurgence in world-wide volatility in stock prices, interest rates, currencies and commodities. This volatility carried over into October as most days so far the Dow has experienced 100 to 200 point swings rather routinely. A lack of global liquidity has also created a resurgence of volatility as the Federal Reserve wraps up its quantitative easing (QE) program. It’s no secret that QE aids global liquidity and risk assets such as stocks. Cross-currents in Central Bank policies also add to volatility. The US and the UK are now looking over the horizon and deciding when to start raising interest rates from zero bound. Meanwhile, Europe and Japan remain at zero and are looking for more ways to add to their own quantitative easing programs.


The end of the quarter also saw the hasty exit of Bill Gross from PIMCO, which no doubt added to volatility as PIMCO manages more than $2 trillion in global assets. In his first letter to clients at his new firm Janus, Gross echoed his views while at PIMCO saying current financial markets are “artificially priced.” It’s hard to argue as he notes there is nothing normal about a 2-year German government bond yielding “minus” .10%. That’s right, investors are paying the German government to hold their money!


Volatility is nothing new in financial markets. One only needs to look at the S&P 500 since 1997 (see figure 1 below). The market has seen its share of volatility in the recent past. What’s been interesting during the past few weeks has been the reaction to all the added volatility. Pullbacks anywhere from 5 to 10% in stocks is a very normal phenomenon. US stocks are only 5-7% off their 52-week highs and international markets have come further off their highs, around 12%. The global stock market is up 10% annually over the past 5 years and returned a healthy 23% during 2014. It’s not unusual for markets to take a “collective breath” after such a strong year in 2013. What’s also possible is many investors continue to suffer from “recency bias” as the fear of the 2008/2009 recession remains in the forefront of their minds.




Figure 1: S&P 500 Index at Inflection Points


Source: JP Morgan


So how do you combat volatility in a portfolio and still maintain a long-term view? A manager that I have used for many years, Jeffrey Gundlach, has said “The trick is to take risks and be paid for taking those risks, but to take a diversified basket of risks in a portfolio.” What Gundlach is communicating is not to blindly invest in risky assets just to seek higher returns, but to be selective in how and where you take your risks. In every market environment there are opportunities. Markets are not perfectly efficient, but rather I believe, somewhat efficient. To me that means using a mix of both active and passive strategies in a portfolio. 


Seek out active managers that can provide downside protection in stocks and other risk assets. In the bond market, especially in today’s market, look for low cost active managers that have the ability to “take risks and be paid for taking those risks.” Holding cash is also not a bad thing in many market environments. Cash can provide a “dry power” asset if and when markets enter a larger correction. One way to hold cash is through active managers. This takes away the need to force a decision from the asset allocation level to hold cash. Steve Romick at FPA Crescent for example, holds 45% of his portfolio in cash as of the end of the third quarter. Let the active managers make the cash decisions for you.


The end of an era of zero-bound interest rates and quantitative easing may be beginning. If so, get used to added volatility in financial markets. Now more than ever is a time to be vigilant about the risks one takes, but still maintain a long-term perspective.



Global stocks ended the quarter down 2.3%. The weakest area of the market was developed international stocks as investors fretted over geopolitical risks, slowing growth and a risk of deflation in the Euro-zone. US stocks were once again the best performers with the S&P 500 rising 1.1% during the quarter. For the year, most markets are showing positive returns with small cap stocks bringing up the rear. Despite a volatile quarter, all markets have been in bull market mode for the past 5 ½ years and also higher than normal 10-year annualized returns. Keeping a long-term perspective is important.



Most U.S. bond markets were modestly higher during the quarter, while international bonds declined. Surprising most investors, the bond market has been very strong during 2014 with the Barclays Aggregate bond returning 4.1% year to date. As interest rates have consistently dropped over the past 10 years, bond prices have risen. With global interest rates near zero, the future looks less bright for the bond market. However, bonds deserve a place in any diversified portfolio.



The third quarter was a tale of two markets for commodities and the US dollar. Perhaps the most volatile of the markets, commodities suffered a 12% drop during the quarter. Commodities were hurt by a stronger dollar which rose 7.6% during the quarter, slowing global growth rates, and inflation near non-existent across the globe.


Balanced Portfolio

A balanced portfolio of 60% world stocks and 40% bonds declined 1.3% during the quarter and is higher by 3.9% so far this year. Despite the 2008/2009 global recession, a balanced portfolio has returned 6.2% annually since October of 2004.





Cumberland Advisors Commentary – Volatility. Available online


JP Morgan Guide to the Markets – 4Q 2014. Available online


Investment Outlook – Bill Gross, October, 2014. Available online





All indexes are unmanaged and an individual cannot invest directly in an index. Index returns do not reflect fees or expenses.


The MSCI ACWI (All Country World Index) Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. As of June 2009 the MSCI ACWI consisted of 45 country indices comprising 23 developed and 22 emerging market country indices.


The S&P 500 Index is widely regarded as the best single gauge of the U.S. equities market. This world-renowned index includes a representative sample of 500 leading companies in leading industries of the U.S. economy. Although the S&P 500 Index focuses on the large-cap segment of the market, with approximately 75% coverage of U.S. equities, it is also an ideal proxy for the total market. An investor cannot invest directly in an index.


The Russell 3000 Index® measures the performance of the 3,000 largest U.S. companies based on total market capitalization.


The Russell Midcap Index ® measures the performance of the 800 smallest companies in the Russell 1000 Index.


The Russell 2000 Index ® measures the performance of the 2,000 smallest companies in the Russell 3000 Index.


The MSCI® EAFE (Europe, Australia, Far East) Net Index is recognized as the pre-eminent benchmark in the United States to measure international equity performance. It comprises 21 MSCI country indexes, representing the developed markets outside of North America.


The MSCI Emerging Markets Index SM is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. As of June 2007, the MSCI Emerging Markets Index consisted of the following 25 emerging market country indices: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.


The Dow Jones Composite REIT Index measures the performance of Real Estate Investment Trusts (REIT) and other companies that invest directly or indirectly through development, management or ownership, including properties.


The Dow Jones-UBS Commodity Index is composed of futures contracts on physical commodities and represents twenty two separate commodities traded on U.S. exchanges, with the exception of aluminum, nickel, and zinc.


The Barclays Capital U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indexes that are calculated and reported on a regular basis.


The Barclays U.S. Treasury Index is U.S. Treasury component of the U.S. Government index. Public obligations of the U.S. Treasury with a remaining maturity of one year or more.


Treasury bills are excluded (because of the maturity constraint). Certain special issues, such as flower bonds, targeted investor notes (TINs), and state and local government series (SLGs) bonds are excluded. Coupon issues that have been stripped are reflected in the index based on the underlying coupon issue rather than in stripped form. Thus STRIPS are excluded from the index because their inclusion would result in double counting. However, for investors with significant holdings of STRIPS, customized benchmarks are available that include STRIPS and a corresponding decreased weighting of coupon issues. Treasuries not included in the Aggregate Index, such as bills, coupons, and bellwethers, can be found in the index group Other Government on the Index Map. As of December 31, 1997, Treasury Inflation-Protection Securities (Tips) have been removed from the Aggregate Index. The Tips index is now a component of the Global Real index group.


The Barclays Short Treasury Index includes aged U.S. Treasury bills, notes and bonds with a remaining maturity from 1 up to (but not including) 12 months. It excludes zero coupon strips.


The Barclays Municipal Bond Index is a rules-based, market-value-weighted index engineered for the long-term tax-exempt bond market. To be included in the index, bonds must be rated investment-grade (Baa3/BBB- or higher) by at least two of the following ratings agencies: Moody's, S&P, Fitch. If only two of the three agencies rate the security, the lower rating is used to determine index eligibility. If only one of the three agencies rates a security, the rating must be investment-grade. They must have an outstanding par value of at least $7 million and be issued as part of a transaction of at least $75 million. The bonds must be fixed rate, have a dated-date after December 31, 1990, and must be at least one year from their maturity date. Remarketed issues, taxable municipal bonds, bonds with floating rates, and derivatives, are excluded from the benchmark.


The Barclays U.S. Corporate Investment Grade Index is the Corporate component of the U.S. Credit index. Publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and quality requirements. To qualify, bonds must be SEC-registered.


The Barclays U.S. Corporate High Yield Index covers the universe of fixed rate, non-investment grade debt. Eurobonds and debt issues from countries designated as emerging markets (sovereign rating of Baa1/BBB+/BBB+ and below using the middle of Moody’s, S&P, and Fitch) are excluded, but Canadian and global bonds (SEC registered) of issuers in non-EMG countries are included. Original issue zeroes, step-up coupon structures, 144-As and pay-in-kind bonds (PIKs, as of October 1, 2009) are also included.


The Barclays Global Aggregate Bond Index provides a broad-based measure of the global investment-grade fixed income markets. The three major components of this index are the U.S. Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices. The index also includes Eurodollar and Euro-Yen corporate bonds, Canadian government, agency and corporate securities, and USD investment grade 144A securities.


The Barclays Emerging Markets USD Aggregate Index is a flagship hard currency Emerging Markets debt benchmark that includes USD denominated debt from sovereign, quasi-sovereign, and corporate EM issuers. The index is broad-based in its coverage by sector and by country, and reflects the evolution of EM benchmarking from traditional sovereign bond indices to Aggregate-style benchmarks that are more representative of the EM investment choice set. Country eligibility and classification as an Emerging Market is rules-based and reviewed on an annual basis using World Bank income group and International Monetary Fund (IMF) country classifications. This index was previously called the Barclays US EM Index and history is available back to 1993.




Past performance is no guarantee of future results. Diversification does not assure profit or protect against a loss in a declining market. While we have gathered this information from sources believe to be reliable, we cannot guarantee the accuracy of the information provided. The views, opinions, and forecasts expressed in this commentary are as of the date indicated, are subject to change at any time, are not a guarantee of future results, do not represent or offer of any particular security, strategy, or investment and and should not be considered investment advice. Investors should consider the investment objectives, risks, and expenses of a mutual fund or exchanged traded fund carefully before investing. Furthermore, the investor should make an independent assessment of the legal, regulatory, tax, credit, and accounting and determine, together with their own professional advisers if any of the investments mentioned herein are suitable to their personal goals.


International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. Small and mid-cap stocks carry greater risks than investments in larger, more established companies. Fixed-income securities are subject to interest-rate risk. Investing in high-income securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. Investing in commodities is generally considered speculative because of the significant potential for investment loss due to cyclical economic conditions, sudden political events, and adverse international monetary policies. There are several risks associated with alternative or non-traditional investments above and beyond the typical risks associated with traditional investments including higher fees, more complex/less transparent investment strategies, less liquid investments and potentially less tax-friendly. Some strategies may disappoint in strong up markets and may not diversify risk in extreme down markets.


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