The Markets	03/31/14   Close	12/31/13   Close	1st  Qtr.  Change	03/31/13   Close	12 Mo. Change	YTD       Change
Dow	16,458	16,577	-0.72%	14,759	+11.51%	-0.72%
NASDAQ	4,199	4,177	+0.53%	3,268	+28.49%	+0.53%
S&P 500	1,872	1,848	+1.30%	1,569	+19.31%	+1.30%
MSCI EAFE	1,916	1,916	+/- 0%	1,675	+11.70%	+/- 0%
10-yr Treas. yield	2.72%	3.03%	-0.31%	1.76%	+0.96%	-0.31%
Fed funds rate	0 to.25%	0 to.25%	n/a	0 to.25%	n/a	n/a

(stock indices are before dividends; yield and rate changes are absolute changes)

After a very strong 2013, and the typical minor ups and downs, the major market indices were close to flat for the first quarter, before dividends. The primary index for developed country international stocks, MSCI Europe, Asia and Far East (EAFE), was exactly flat. March 9 was the fifth year of the current bull market and on that anniversary of the market bottom the Dow had increased 151%, the S&P 500 was up 177% and the NASDAQ was up 242%, including dividends. Of course, picking a market bottom is impossible so those returns were afforded to those who were already invested on March 9 or who had stayed invested through the entire down and up cycle.

Most economic data trended positive during the quarter. Both services and manufacturing showed strong growth momentum, consumer confidence hit a six-year high (confidence in current conditions was down but future expectations were up) and inflation was nearly non-existent. Core capital goods (non-defense excluding aircraft), a proxy for business spending, was up two of three months. Jobless claims conintued their slow decline and unemployment dropped to 6.7%. Housing began to show a little fatigue with one measure of home prices down for the last three months but up over 13% from a year ago. Sales of both new and existing homes were only slightly up and new household formations dropped. The final revision for GDP growth for the fourth quarter was 2.6%, down from the initial 3.2%.

Following the close of the winter Olympics, Russia quickly escalated its dispute with Ukraine, ultimately tossing Ukraine out of Crimea, facilitating a referendum in which Crimeans overwhelmingly voted to join Russia and amassing troops on its border with eastern Ukraine. The US and its European allies initially had very little leverage to counter Russia’s aggression, freezing the assets of highly-placed Russians. Eventually the US pledged $1 billion in aid to Ukraine and the International Monetary Fund offered to lend $14 to $18 billion on the condition that Ukraine enact economic reforms. A wider crisis was averted for the time being.

Congress avoided a repeat of last fall’s drama and voted to increase the debt ceiling with no conditions. The supposed revolution of digital currencies suffered a big setback as Mt. Gox, a major bitcoin exchange, filed for bankruptcy and could not account for hundreds of millions of dollars worth of bitcoin. Chinese manufacturing slowed considerably and Chinese inflation also slowed, raising some fears of global deflation. Still, the International Monetary Fund raised its forecast for 2014 global growth to 3.7% from 3%.

Obamacare finally reached its much-delayed deadline for initial enrollment and 7 million Americans did actually secure health insurance under the program, reaching the stated initial goal. Opinions and projections abound as to what the eventual economic impact will be but the longer the coverage is in place and the more people are covered the harder it will become to make any real changes. The government also sold the last of its stock in General Motors, netting around a $10 billion loss. Still, it was a very good move as GM later became embroiled in a scandal over an inexpensive repair that was covered up and did not result in a recall. In the interim, 13 deaths were attributed to the flaw and GM testified before Congress and struggled to salvage its reputation.

Looking Forward

We forget that the weather can still have a profound effect on business and the economy, especially when we’re basking in the balmy Tucson winter. But the brutal winter in most of the country did have a major impact in many ways, from hiring, hours worked and retail sales to housing and local government budgets. The expectation is that with the arrival of spring the economy will gain steam or at least pick up some of that slack. If it does not, it could indicate some underlying weakness. Initial signs were inconclusive, with March jobs added coming in just under expectations.

The economy has now replaced the private sector jobs lost during the Great Recession but that is not being hailed as any great milestone. As noted elsewhere in this review the unemployment rate is still stubbornly high, there are still too many long-term unemployed workers and compared to 2009 the labor participation rate is lower and real wages are lower. Jobs will likely return to the forefront as the bellwether indicator of the economy’s strength, regardless of other data. Jobs are, simply put, something everyone can understand.

As distasteful and frustrating as it will likely be, the mid-term elections will begin to heat up. On the one hand, President Obama is entering the lame duck years of his final term so it is less likely that much will change or get done. On the other hand, there is always the chance that the Republicans could gain control of both houses of Congress, which could lead to some new legislation. In either case the elections will be a distraction, during which the economy could continue to heal without interference.

Our Portfolios

The obvious objective of portfolio management is the pursuit of returns while balancing risk. Along the way, though, the ups and downs of markets can create plenty of anxiety and the emotional impact of portfolio management should not be overlooked.

In his 2001 book Fooled by Randomness: The Hidden Role of Chance in Life and the Markets, Nassim Taleb very nicely illustrated the impact of hovering too closely over a portfolio. He cites “prospect theory” which says that for every good result you see, you gain one Emotional Unit. However, a loss has twice the impact on emotions, so for every bad result you lose two Emotional Units.

Brandes Investment Partners then applied this idea to create a Wheel of Emotion for a hypothetical balanced portfolio that was held for 20 years and used longer-term market performance to assess the likelihood of outcomes (that is, the portfolio was held for 20 years but the results were based on longer-term performance results rather than a particular 20-year period).

Checking the portfolio daily had a 54% chance of seeing a gain on any given day. But you would lose 6,716 Emotional Units as opposed to gaining only 3,942 Emotional Units. It is more likely that the portfolio is growing but you still feel pretty lousy because you have lost twice as many Emotional Units as you gained.

Checking the portfolio monthly had a 67% chance of seeing a gain and a pretty equal ration of emotional gains and losses (161 Units gained and 158 lost.) Checking quarterly finally tipped the scales to a positive emotional result; there was a 77% chance of seeing a gain and almost twice as many Emotional Units gained (62) versus lost (36). You were finally able to enjoy the positive portfolio results. Not surprisingly, checking the portfolio annually had the best results all around, with a 93% chance of seeing a gain and 10 times as many Emotional Units gained (19) versus lost (2).

The point is not that a portfolio should only be assessed once a year or at any set interval. The Wheel does present a valuable way to balance emotion with decisions regarding the portfolio. Not only does more frequent monitoring add to negative emotions but it also increases the tendency to abandon an investment that would likely produce positive long-term results. And since the time that Taleb and Brandes presented their analysis the news and information cycles have only accelerated, adding to the pressure to always check a portfolio. More negative emotions yield more potentially damaging impulsive, short-term changes.

Our portfolios have always been based on long-term objectives and are built to look beyond market volatility. Broad diversification serves to smooth company and industry risk and thoughtful asset allocation creates reasonable likelihood of meeting financial goals. We take this approach not due to laziness or a lack of sophistication but because it is a proven approach which discourages constant hand-wringing and supports our clients having positive financial and emotional results.

Of course, this approach is routinely derided as old-fashioned and not as current as “stock-picking”, “alternatives” and other approaches. Over time, none of these has proven to be an improvement over a balanced approach when considering both results and emotions. We’ll let the salesmen and pundits debate these other methods while we calmly and quietly go about our business of helping our clients enjoy the fruits of their savings.

Fed Up?

The Federal Reserve implements monetary policy for the world’s largest economy with the dual mandate of maintaining employment levels and stable prices. The Fed also strives to influence interest rates, supervise banking institutions and ensure the stability of the entire financial system. Little wonder that the role of Fed Chairman is seen as the second most powerful position in the world and that every step or statement by the Fed is exhaustively scrutinized.

Still, the “Fed watch” can take on a life of its own, and that life is sometimes pretty silly. In the 2000’s, CNBC created its famous “briefcase indicator”. Their cameras would follow Alan Greenspan on the mornings of the Open Market Committee meetings, in which decisions about short-term interest rates were made. If his briefcase was thin it supposedly meant his mind was untroubled and the economy was well, with no change in rates. But if it was stuffed, he had supposedly been deep in analysis and was carrying documents to support the case for a rate hike. The whole thing was far better theatre than indicator.

The Fed traditionally offered only vague, short-term guidance about its actions. It was reluctant to suggest any long-term plans for fear that markets would act on assumptions and if the Fed did not actually follow those assumptions markets would be severely disrupted. That worked well, as market participants knew they were on their own for their long-term plans and could not blame the Fed if they guessed wrong.

Then came the financial crisis in 2008 and not only did the Fed very actively intervene to stabilize the financial system, they felt it necessary to offer long-term assurances that interest rates would stay low to calm nervous markets. Terms like “considerable period” and “foreseeable future” came to describe their intentions. Market participants could confidently borrow at low short-term rates and lend at higher long-term rates without fear that short-term rates would unexpectedly jump.

But that wasn’t enough. The Fed began a series of “quantitative easing” (QE) programs which meant buying bonds to inject more money into the system. There were three rounds of QE using various techniques and amounts, with the cumulative result being four years of almost continuous Fed buying. With each round market observers would speculate on the timing and details rather just waiting to hear the Fed’s plans.

In 2013 the Fed took the unprecedented step of identifying specific economic targets before they would raise short-term rates. Rates would stay low until unemployment went down to 6.5% or the inflation rate reached 2.5%. The market loved that certainty but as unemployment reached 6.7% this year the Fed changed its tune because there are still so many people who have dropped out of the workforce, making the official unemployment rate less indicative of the health of the labor market.

At the same time, the Fed began to signal that it would begin to wind down its bond-buying spree, which everyone knew would have to happen at some point. Every piece of economic data and every word uttered by the Fed was seen as making the “taper” more or less imminent and the market would make pretty significant moves. As overblown as they were, those reactions helped the “taper” become a non-event when the Fed actually began reducing its bond purchases.

Having kept rates low for so long and signaling well in advance its recent moves, the Fed is now left with little else to do but talk rather than act. That became apparent with new Fed chair Janet Yellen’s first policy meeting. In the press conference that followed, she was asked over and over when interest rates would rise when the bond buying ends this fall. After giving many vague answers she made a passing remark that it could be six months. And the markets immediately fell.

Janet Yellen and the Fed have an unimaginably difficult job. Unfortunately, the relentless news cycle makes news where there is none, making that job even more challenging.