October 2013

Equities vs. Bonds

Third Quarter 2013
When you sit back and look at the stock market over a sufficient period of time, you can develop perspective. When you are looking at it daily, however, you may lack perspective and become emotional. The third quarter was a period that requires perspective to remain objective.

The quarter began with the market in an uptrend, after coming off a low point on June 24th of the second quarter. The S&P 500 began in July at 1610 and rose until August 2nd, when it hit 1710. Not bad, up 100 points or a little more than 6% in one month. Ah, but the market is never predictable. By August 30th, the market had fallen to 1633, a drop of 77 points or 4.5%. Never fear: back up it went, and by September 18th all was well, as it hit a new high of 1726. This was a rise of 93 points or 5.7% from the end of August. If it had just stayed there until the end of the month, it would have been nice. At this point, however, the U.S. Government was unable to come to a compromise over the new fiscal year budget and the markets reacted by heading down. By September 30th, the S&P had fallen by 44 points or 2.6%. With perspective, we can look at the quarterly picture and see the S&P 500 rise by 72 points or about 4.5%. Not a bad quarter after all!

Bonds fared much the same as stocks. Bond prices went down, then up, then down. Unfortunately, bond prices were more sensitive to the government’s lack of direction. At the end of the quarter, prices were up marginally. They fared better in October, once the government reopened and the debt ceiling issue was pushed into 2014.  

Federal Reserve Board
During the latter part of the second quarter the Federal Reserve Board (Fed) mis-stepped by signaling they were going to slow down, and eventually eliminate, buying $85 billion of bonds and mortgages monthly. The economy was not strong enough to with-stand such news at the time. It caused the stock and bond markets to lose value.
During the second quarter, the Fed did a reassessment of their program and decided that they would likely maintain the level of buying until sometime next year. This announcement helped calm the markets as they faced the government shutdown and the debate over the debt ceiling.
When Ben Bernanke steps down in January, it appears Janet Yellen will take his place as Fed Chairman. This too has been good news to the markets.  Yellen is seen as a Dove and will likely continue Bernanke’s careful approach to a fragile economy. She is likely to take baby steps in reducing the Fed buying activity in the future. This in turn would be good news for bonds, as the transition back to normal longer-term interest rates would be orderly, with no change likely for short-term interest rates for some time to come. This is also good news for stock investors because the buying activity has put greater liquidity into the marketplace, which increases stock values.

Bonds and Conservative Investors
Over the long-term it seems likely that the Fed will let medium and longer-term interest rates rise. This will not be good for the value of bonds over such periods. Bonds move inversely to interest rates. In other words, when interest rates rise, the value of bonds drops. Investment grade bonds are considered to be a more conservative investment than stocks. When you buy investment grade bonds, you are buying an IOU issued by a credit-worthy corporation or municipality. The interest rate is fixed and the maturity is fixed. If you were to buy a $1,000 bond paying 4% interest, you would receive a payment of $20 twice each year. At the maturity date, you’d receive your $1,000 back. The potential problem arises if you want to sell your bond when interest rates increase.

Let’s say that, at the time you want to sell your bond, interest rates are 5%. A buyer would not want to buy your 4% bond for the full price if they can buy bonds with interest of 5%. In such an event, your bond is sold for less than the $1,000 you paid for it, to give the buyer the equivalent of a 5% interest rate. When pricing bonds for your statement, this change in interest rate is taken into account and impacts the value of your account. For the past number of years, the interest rates have been decreasing, thereby increasing the principal value of your bonds. As interest rates rise, which we are expecting will happen soon, the value of bonds drops.
What do you do in such an environment? You invest in shorter-term bonds where the change in interest has a lesser impact on the value of the principal. Unfortunately, to move to shorter durations also means lower interest rate earnings.
All of this presents a major dilemma for conservative investors, because the bulk of their investments are usually in fixed investments (i.e. bonds).  Many conservative investors are also retirees who are using the income from the bonds to live. This presents a real living-standard problem.
What is likely to happen in the future is that interest rates will rise, then level off and normalize. During this transition period, you are left with the choice of going with short-term bonds that pay less, or taking your chances with intermediate-duration bonds that will be more subject to changes in interest rates. The solution is likely to be some of each, recognizing it may not be a smooth ride for a year to eighteen months, in my estimation.

If you are single and earn less than $200,000, or married and earn less than $250,000, you will likely be OK for 2013. If you earn more than these amounts you may owe more taxes than you have anticipated. You may want to check with your accountant about adding funds to your withholding, so that you don’t pay penalty and interest charges in addition to the greater amount of tax. Here is a quick summary of what is happening: Over certain amounts, a 3.8% surtax on Modified Adjusted Gross Income goes to Medicare. Over certain Adjusted Gross Income earning amounts, both itemized deductions (ID) and personal exemptions (PE) are reduced. The net effect is to increase your taxes by about 1%. Finally, a new 39.6% tax rate has been created. The chart below illustrates these changes:
Summary of Thresholds
        Single        Married
3.8% Surtax     $200,000    $250,000
PE & ID    $250,000    $300,000
39.6% Tax     $400,000    $450,000

With these taxes come several traps. The surtax will be taken as withholding if your pay goes over $200,000.  If you are married, however, with a combined income over $250,000 you will likely NOT have sufficient surtax withheld. For example if each spouse earned $150,000, the combined income of $300,000, would not have had the surtax deducted.  The amount owed would be $1,900. The PE and ID did not exist last year and, therefore, you will owe taxes if you are in this category.

Ed Mallon