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Third Quarter 2013 Newsletter

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Third Quarter 2013 Key Takeaways

Despite these twists and turns, stocks posted another strong quarter. Large-caps rose 5% and are now up 20% for the year. These gains have occurred even as the U.S. economic recovery remains only moderate and corporate earnings growth has slowed.

International markets improved in the third quarter following a rocky start to the year, particularly for emerging markets. Among emerging markets, China showed signs of stronger growth (albeit at a lower rate than in prior years) so this was an overall positive given the country’s significance among emerging (and developed) market economies. Emerging markets as a group rose in aggregate for the quarter (despite losses for some countries) and developed international markets outperformed U.S. stocks by a wide margin.

Core bonds in aggregate were modestly positive for the quarter thanks in large part to a rebound in September as both the Fed’s decision to stand pat and investor risk-aversion in the face of an impending budget stalemate (and looming debt-ceiling standoff) were favorable for bonds. Absolute-return-oriented and flexible bond funds collectively outpaced core bond funds during this changing fixed-income environment.

We continue to believe we are investing in a time of uncertainty, where an unusually broad range of outcomes remain possible. Building a sensible portfolio strategy in this environment is not just about having different pieces in place to ensure the portfolio can withstand different scenarios, it is also about understanding the risk and reward of each asset, the role of each asset in the portfolio, and how assets interact with each other.

An important part of our investment discipline is to protect client portfolios against risk scenarios we believe are plausible and not already adequately factored into asset prices. Taking this precaution means we will likely lag the broader stock market if these risk scenarios do not play out. However, the fear of leaving some money on the   table over short periods is not sufficient cause to deviate from the investment discipline that has served our clients well over the long term.

Third Quarter 2013 Investment Commentary

The word “fiduciary” is defined as “relating to, or involving one that holds something in trust for another.”    Another word that goes hand in hand with being a fiduciary for our clients is “prudence,” which is defined as “careful management.” In our industry, these words—fiduciary and prudence—are used liberally. We want to share what these words mean to us and how they influence our day-to-day management of client portfolios.

Our typical client in a balanced portfolio expects us to maximize long-term return without taking on substantial market risk. There’s an inherent trade-off in this dual objective. Managing to a downside risk threshold sometimes means we have to be willing to leave some return on the table. We have always said we do not manage portfolios to one economic or asset-class scenario because we don’t think we can know with confidence which scenario will play out. We hope optimistic scenarios play out, but do not build portfolios based on them unless we believe they are likely. Investing based on hope would not be in line with acting as a responsible fiduciary for our clients who have specifically entrusted us with the mandate to care about downside risk.

Managing portfolios to withstand various scenarios is as much art as science. In shielding our clients from one scenario, we expose them to others. The key is to strike a reasonable portfolio balance that allows us to meet our clients’ risk and return objectives over the long term. Both inflation and deflation risks exist, and both are bad for risk assets. Our economy is still fighting significant deflationary headwinds due to ongoing private- and public-sector deleveraging. At the same time, the experimental monetary policy of keeping short-term interest rates near zero over extended periods could easily stoke inflation, and we don’t know if and when that would    occur. In this inflationary scenario our clients would expect us to protect their purchasing power. It would be nice if we had a crystal ball to know which outcome will occur and when, so we can position our clients’ portfolios   accordingly. But part of being intellectually honest is acknowledging that we do not have a crystal ball and there are many unknowns, especially now, when we are going through a major deleveraging episode and the range of possible outcomes is unusually wide. Our job becomes harder in a period when most assets appear to be richly valued. So, how do we balance out two extreme risks—inflation and deflation—given each scenario warrants a vastly different portfolio positioning?

To protect client portfolios from a recession or deflation outcome, we continue to recommend and hold positions in investment-grade or core bonds. In such an environment, interest rates would likely fall, and core bonds would increase in value as most risky assets are declining. Given their very low interest yield levels, core bonds would not give as much protection as they did in the past, but would still do a much better job of protecting capital than most other asset classes in this scenario.

That said, we acknowledge that relative to history, core bonds carry a significant opportunity cost. Despite a recent spike, interest rates remain very low by historical standards, which mean that expected returns from core bonds are extremely low. As a result, a significant amount of our bond recommendations have gone to absolute-return-oriented and flexible bond funds. Over 12 months, in a recession/deflation scenario, these bond funds are likely to lag core bond funds that have a longer duration and heavier emphasis on Treasury bonds. But over a five-year investment horizon, absolute-return-oriented and non-core bond funds are likely to generate significantly better returns. The value of these bond funds comes from their underlying managers’ ability to add value by investing opportunistically across fixed-income sectors (without being constrained by the core benchmark) as well as from individual issue selection.

Over a 12-month period, we expect our absolute-return-oriented and non-core bond fund investments to have much less downside risk than stocks. Through a strong period for stocks, they have provided a reasonable return with much less risk. In addition, by having a lower allocation to stocks, we worry a bit less about capital preservation in a deflation/recession scenario and can afford to have less protection in the form of core bonds, which, in addition to having poor return prospects over our five-year investment horizon, expose us to the risk of rising interest rates.

Rational Reasons for a Bearish View on U.S. Stocks

Chart 1Over the past two years or so, GAAP trailing 12-month earnings have gone nowhere but the market has continued its ascent, especially over the past year. The S&P 500 now trades at a price to earnings ratio (P/E) of 19 times trailing 12-month earnings. The price to earnings ratio of the market is a useful measure to observe because it illustrates what investors are willing to pay for one dollar of earnings and therefore indicates how overvalued or undervalued the market may be. Under normal market conditions, we consider a price to earnings ratio of 15-17 times earnings to be indicative of a fairly valued market. This is an average historical multiple excluding the market’s frothiest periods and a prudent multiple in our view given the deleveraging headwinds that are still in place. If the S&P 500 were to trade at 15 times current trailing 12-month earnings, it would imply a price of around 1,350 on the S&P 500 index, i.e., a decline of roughly 20% from present levels.

On the other hand, given that most investors expect the Fed to keep short-term rates near zero until 2015 at least, P/E multiples of 18–20 times earnings are quite conceivable in this environment, and quite normal to most investors who in their professional lives have only experienced the post-1980′s investing world. Applying those P/E multiples to our normalized earnings five years out, then adding a dividend yield of slightly over 2%, we get returns in the 6%–8% range—not bad at all considering that the expected returns of other asset classes we can invest in are generally lower.

Why Bother Investing Outside the United States?

This is a question we have been getting more frequently in recent times. We were getting similar questions back in the late 1990s after U.S. stocks experienced a great run of outperformance over international stocks. Developed international stocks subsequently went on to outperform U.S. stocks for six years, and emerging-markets stocks did even better. The most important reason for having a globally diversified strategic mix is that it should provide a much smoother ride than just being invested in U.S. stocks. The second reason to invest outside the United States is to tap into a broader investment opportunity set—much of which is not well-covered by Wall Street—allowing active managers to add significant value.

Chart 2The case for having a dedicated long-term allocation to emerging markets is particularly  compelling. On a purchasing-power-parity basis, emerging-markets’ share of world GDP has grown from 37% in the late 1990s to nearly 50% as of 2012. Yet emerging markets still represent a much smaller share of global market value (on a market cap basis). The rapid pace of knowledge transfer from developing nations ultimately contributes to higher productivity, per-capita incomes, GDP, and profit growth in emerging economies. As this plays out emerging-market countries will see the gap narrow between their share of world GDP and market cap. We want our clients to participate in this long-term opportunity.

Taking Stock of Emerging Markets

Emerging-markets stocks were hit especially hard this year after the Fed indicated its intent to taper QE, and over the last couple of years have underperformed U.S. stocks. For some of our clients, who are comfortable with the risks of investing in emerging-markets, we have taken advantage of the recent volatility to make an opportunistic investment. However, as we’ve reiterated along the way, the primary reason we have not made a recommendation for all of our clients to make a sizeable investment in emerging-markets is related to our ongoing concern about China’s credit and infrastructure bubble. Also, as we have mentioned in the past, emerging-market stocks have many other risk factors, such as political risk and currency risk, which are not as prevalent in the developed world. Because of these risks we believe it is reasonable to expect that emerging markets stocks will continue to be more volatile than U.S. and European stocks.

Coming to emerging-markets local-currency bonds, they too suffered this spring and summer as emerging-markets currencies declined versus the U.S. dollar. Therefore, we believe it is important to review how we think about this allocation. Our time horizon for this type of investment has always been longer than the five years   for typical stock and bond mutual funds. We see it as a good way to hedge a potential decline in the U.S. dollar/U.S. inflation. Insuring against this risk remains prudent in our view, given the Fed’s unprecedented monetary policies in recent years that have bloated its balance sheet. In aggregate, long-term fundamentals—primarily balance sheets and growth prospects—for emerging markets are stronger than the United States. As such, in a normal scenario we believe we can get at least mid- to upper-single-digit returns over our investment horizon. These returns are better than what we expect from U.S. stocks in our likely subpar recovery scenario. Finally, to adequately factor in emerging-markets currencies’ equity-like risk, which we clearly experienced this summer, we fund them mostly from U.S. stocks. Overall, looking out five years and longer, given the role they are playing in the portfolio and taking into account the risk from our allocation to emerging-markets stocks, we remain comfortable recommending that our clients hold their positions in emerging-markets bonds.

We believe the problems we’ve seen this year in emerging markets are only a blip on what we expect to be a very long-term, upward path. At the same time, we are cognizant of and continue to analyze risks to our emerging-markets investment thesis, but that does not negate the strategic case for owning emerging-markets stocks (and bonds) in client portfolios.

Parting Thoughts

An important part of our investment discipline is to protect client portfolios against downside risk scenarios we believe are plausible and not already adequately factored into asset prices. Taking this precaution means that at times investment performance is likely lag the broader stock market if a more optimistic scenario plays out.  However, the fear of leaving some money on the table over short periods is not sufficient cause to deviate from the investment discipline that has served our clients well over the long term.

Please feel free to contact us at any time with any questions or concerns. We appreciate your confidence and loyalty.
Wilson Financial Advisors, Inc.
Kent L. Wilson, CFP®, CPA, Thomas Fritz, CFP®, Kenneth R. Poulsen, CFP®, Carol A. Wilson, Founder

The Investment Letter is mailed quarterly to our clients and friends to share some of our more interesting views. Certain material in this work is proprietary to and copyrighted by Litman/Gregory Analytics and is used by Wilson Financial Advisors, Inc. with permission. Reproduction or distribution of this material is prohibited and all rights are reserved.

Second Quarter 2013 Newsletter

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Third Quarter 2013 Key Takeaways

Federal Reserve policy has been a significant force driving market performance over the past few years and this was especially true during the second quarter as investors reacted to comments from Fed policymakers indicating the Fed might begin reducing its bond buying program sooner than had been expected.

Against this backdrop, U.S. stocks suffered losses in June but ended the quarter with gains (though stocks were down from earlier year highs). Core investment-grade bonds fell 2% for their worst quarter since 2004 and other interest-rate sensitive asset classes such as REITs were negative as well. Emerging-markets stocks and bonds lost ground both due to concerns about changes in U.S. monetary policy and potentially slowing growth in many emerging-market economies.

There were two second-quarter market developments we find particularly noteworthy: the spike in Treasury bond yields and the sharp decline in emerging-markets stocks and bonds.

Our longer-term outlook and asset class analysis has had us positioned for a rise in rates (and a decline in bond prices) for a while now, reflected by our underweight to core bonds and overweight to flexible/absolute-return-oriented bond strategies.

Although we do consider potential shorter-term risks in managing our portfolios, we don’t try to predict what markets will do over the short-term or position our portfolios for particular short-term outcomes. The events of the past quarter have not materially changed our longer-term asset class views or risk assessments.

With regard to emerging markets, while we believe the recent sell-off is overdone and short-sighted, we remain cognizant of the potential fundamental risks to emerging markets, most notably a sharp slowdown in China or unexpected inflation.

While it can be uncomfortable to see short-term losses in one’s portfolio and financial markets falling across the globe, we actually welcome this recent market volatility as it has the potential to create more attractive, if not outright compelling, long-term investment opportunities if investors overreact and cause markets to overshoot to the downside as is often the case.

Second Quarter 2013 Investment Commentary
Our commentary will focus on two market developments during the quarter that are noteworthy at both a macro level and given our portfolio positioning: (1) the spike in Treasury bond yields, and (2) the sharp decline in emerging-markets stocks and bonds. Both of these developments had (to varying degrees) the same underlying driver: statements from the Federal Reserve about the future course of monetary policy, and specifically the Fed’s plans to begin “tapering” its quantitative easing bond-buying program. This is a theme we’ve written about a lot recently: the unusually heavy influence of monetary policy on the financial markets in the aftermath of the 2008 financial crisis, and the unusually strong sensitivity of markets to perceived changes to such policy. We’ve noted how Fed policy-by “repressing” interest rates to all-time lows and aggressively purchasing government and mortgage-backed bonds via quantitative easing-actively encouraged (if not forced) investors to move out on the investment risk spectrum, into higher-yielding but riskier asset classes. In our view, this had helped to boost the U.S. stock market to levels beyond what was justified by the longer-term economic (earnings) fundamentals.

We noted that this behavior could certainly continue in a self-reinforcing cycle as long as the markets believed two things: (1) that the Fed would keep up their stimulative policies and, (2) that such policies were necessarily positive for stocks rather than, say, indicative of the severity of our economic problems. If so, as the markets moved higher, more and more short-term-oriented or performance-chasing investors would feel the urge to jump on the stock market bandwagon, propelling the market still higher and further divorcing it from its underlying longer-term economic fundamentals.

That short-term speculative approach is not part of our investment discipline nor is it likely to yield consistent, sustainable success for most investors. That does not mean that we ignore what the Fed is doing, how their policies might change, or what the implications might be for the economy and financial markets. But maintaining an awareness of different possible monetary policy scenarios and outcomes is very different from making portfolio decisions based on the confidence that we know which particular scenario will play out over the short-term and that we can get the timing right.

Development #1: Interest Rates Spike Higher

Interest Rates Spike Higher

Chairman Ben Bernanke indicated on June 19 that the Fed might begin to taper the pace of monthly bond purchases sooner than expected. Despite Bernanke’s best efforts to manage market expectations and communicate that a potential tapering does not mean an actual tightening of monetary policy, investors reacted with alarm to the prospect of a less active Fed. This resulted in a bond market sell-off, with the yield on the 10-year Treasury bond rising from a year-to-date low of 1.63% on May 2 to 2.6% on June 24, its highest level since early August 2011, before ending the quarter at 2.5%. (As a reminder, bond yields rise when prices fall.) U.S. stocks also fell but rebounded fairly quickly.

Chairman Ben Bernanke indicated on June 19 that the Fed might begin to taper the pace of monthly bond purchases sooner than expected. Despite Bernanke’s best efforts to manage market expectations and communicate that a potential tapering does not mean an actual tightening of monetary policy, investors reacted with alarm to the prospect of a less active Fed. This resulted in a bond market sell-off, with the yield on the 10-year Treasury bond rising from a year-to-date low of 1.63% on May 2 to 2.6% on June 24, its highest level since early August 2011, before ending the quarter at 2.5%. (As a reminder, bond yields rise when prices fall.) U.S. stocks also fell but rebounded fairly quickly.

Thirty-year fixed mortgage rates, which are a specific target of QE (quantitative easing), also jumped sharply. Thus, the Fed’s optimism about economic growth/recovery, which led Fed policymakers to conclude they could begin ending QE, might in fact become a headwind to that growth. Rising borrowing costs and falling asset prices could short-circuit the economic recovery and, in turn, the tapering process.

This is just part of the broader challenge the Fed faces as it tries to unwind its unprecedented post-crisis monetary policies without causing any major market or economic disruptions. At best, we are confident in saying, the “exit” will be a very bumpy road, with meaningful risks of policy errors and unintended consequences.

Development #2: Emerging-Markets Bonds and Stocks Sharply Declined

Emerging-Markets Bonds and Stocks Sharply Declined

The second key development last quarter was the sharp sell-off in emerging-markets stocks and emerging-markets local-currency bonds, and their continued underperformance this year relative to U.S. stocks. While there were numerous drivers of this underperformance, the rise in interest rates in the U.S. and the Fed’s tapering announcements were key factors. These developments, along with news that the Japanese central bank was not planning to further expand its own QE program, triggered a general unwinding of the “carry trade,” in which investors (mostly short-term traders and hedge funds) borrow the currencies of countries with low-yielding debt and/or depreciating currencies and invest in higher- yielding/appreciating currency investments, such as emerging-markets local-currency bonds. As the carry trade unwound, prices on emerging-markets local-currency bonds dropped, yields rose, and emerging-markets currencies depreciated against the dollar. Thus, emerging-markets local-currency bonds were hit with the double whammy of falling bond prices and falling currencies.

In addition to the markets’ worries about reduced central bank liquidity, ongoing concerns about a general slowdown in emerging-markets growth and disappointing economic data out of China in particular, as well as fears of a liquidity/credit crunch there, weighed on emerging-markets stocks during the quarter. In contrast, investors seemed to be getting more optimistic about U.S. economic and growth prospects, lending support to the U.S. market.

Portfolio Positioning and our Long-Term Performance Expectations
For the past few years, the fixed-income portions of our portfolios have been positioned for what we expect to be a longer-term trend of rising interest rates. We have been avoiding core bond funds that hold large positions in the most interest rate sensitive securities such as Treasury bonds. In place of core bond funds we currently favor flexible, unconstrained and/or absolute-return-oriented fixed-income funds.

Second, although our balanced portfolios are underweight to equity risk overall, all of that underweight is coming from an underweight to U.S. and developed international stocks. We have an ample allocation to emerging-markets stocks in many of our client portfolios. This was a major headwind to performance given the wide differential in returns for emerging-markets stocks versus U.S. stocks during the quarter.

These two opposing forces combined with other aspects of our positioning, such as our overall equity underweight, resulted in more muted short-term results for our portfolios. However, we view this short-term performance in the context of our longer-term views and objectives for our client’s portfolios.

As we write this, the events of the past quarter have not materially changed our longer-term asset class views or risk assessments. Our underweight to U.S. stocks is not driven by a short-term view of the market, or by a specific concern that interest rates will continue to spike higher in the near-term or that even a moderate but sustained rise in rates should cause a sharp market downturn.

Rather, our underweight to U.S. stocks is driven by our analysis that at current levels the market is implicitly discounting too high a growth rate in corporate earnings over the next five years, and therefore is overvalued and likely to deliver subpar returns over that time horizon.

U.S. core bonds also look very unattractive over a multi-year horizon. We do think stocks will out-return bonds over the next five years, but core bonds also have much lower downside risk than stocks. For the majority of our clients who are not able or willing to withstand full equity-market risk in their portfolios, we still need to own lower risk (and potentially lower-returning) instruments.

Just as interest rates might continue to spike higher driven by investor sentiment and market momen-tum, the negative impact on emerging-markets stocks and emerging-markets local-currency bonds could continue as well over the shorter-term. But in this case we think the markets are over-reacting to short-term developments that we don’t think take into account the longer-term, positive economic fundamentals and attractive absolute return potential for these emerging-markets asset classes.

Consequently, our investment recommendations have not substantially changed and we will remain patient for the markets to present us with better return opportunities before we are willing to increase our overall portfolio risk exposure for our clients. To the extent the recent market volatility continues, our analysis of the relative risks and returns may change, and we are evaluating this with respect to emerging-markets asset classes in particular at the moment.

Concluding Comments
While it can be uncomfortable to see short-term losses in one’s portfolio and financial markets falling across the globe, we actually welcome this recent market volatility as it has the potential to create more attractive, if not outright compelling, long-term investment opportunities if the investing herds over-react and cause markets to overshoot to the downside. We would like nothing more than to see riskier asset classes, such as U.S. stocks, fall back to levels where our analysis indicates they are at least reasonably valued relative to their fundamentals and therefore likely to deliver returns at least commensurate with their risk. We are not there yet.

We are confident, however, that by remaining aware of overall portfolio-level risk and setting allocations accordingly, making investment changes only when compelling opportunities are presented to us, and using managers we believe to be highly skilled, we can continue to earn above-average long-term returns while keeping our shorter-term downside risk within our loss thresholds. One consequence of our approach is that we know we will underperform over some shorter-term periods, and even potentially multi-year periods because of market momentum and other short-term factors. But as long as our positioning remains supported by our analysis of the evidence and facts (as we see them), we will remain disciplined and patient in order to allow our investment decisions to ultimately pay off, as we have seen happen repeatedly in the past.

Please feel free to contact us at any time with any questions or concerns. We appreciate your confidence and loyalty.
Wilson Financial Advisors, Inc.
Kent L. Wilson, CFP®, CPA, Thomas Fritz, CFP®, Kenneth R. Poulsen, CFP®, Carol A. Wilson, Founder

The Investment Letter is mailed quarterly to our clients and friends to share some of our more interesting views. Certain material in this work is proprietary to and copyrighted by Litman/Gregory Analytics and is used by Wilson Financial Advisors, Inc. with permission. Reproduction or distribution of this material is prohibited and all rights are reserved.