The Markets	06/30/13   Close	03/31/13   Close	2nd Qtr.  Change	06/30/12    Close	12 Mo. Change	YTD       Change
Dow	14,910	14,759	+1.02%	12,880	+15.76%	+13.78%
NASDAQ	3,403	3,268	+4.13%	2,935	+15.95%	+12.68%
S&P 500	1,606	1,569	+2.36%	1,362	+17.91%	+12.62%
MSCI EAFE	1,639	1,675	-2.15%	1,423	+15.18%	+2.18%
10-yr Treas. yield	2.48%	1.85%	+0.63%	1.66%	+0.82%	+0.72%
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)

 

The quarter was decidedly mixed, with the broad US stock indices hitting new highs in mid-May only to give back most of those gains by quarter-end. Still, the modest overall gains for the quarter meant the best first half of the year for stocks since 1998. International stocks were mixed, bonds suffered as interest rates popped, and gold took it in the chin as the latest reading on core inflation was near a record low.

Housing was widely seen as a leading contributor to confidence and the economy (some thoughts on housing’s prospects are noted below). Several measures showed housing prices up over 12% from the prior year, the best reading in seven years. Nevada prices were up 26% with Arizona up nearly 17%. Sales of both existing and new homes, as well as pending sales, hit six year highs and housing inventories are well below the six-month level of a balanced market. Tighter procedures for lenders slowed foreclosure proceedings, rising prices are helping underwater homeowners and institutional investors are buying homes in bulk in some markets. Still, overall sales are below the level needed to sustain healthy housing and overall prices are well below the 2006 peak, so the damage of the housing bubble is far from resolved.

Jobs continue to scratch for improvement, with the data still inconclusive. May unemployment fell in half the states but overall unemployment rose to 7.6%. The four-week average of initial unemployment fell below the 350,000 level necessary for a healthy labor market, but the worker participation rate barely budged from its 34-year low.

Things look much brighter here at home compared to Europe. The European central bank cut interest rates for the first time in 10 months from 0.75% to 0.50% in a desperate attempt to generate any positive activity. The overall EU went into its sixth quarter of recession, with France joining the other countries in recession. Unemployment in the 17 countries using the euro hit an all-time high since the euro’s introduction of 12.2%, with 25% joblessness for workers under age 25. Spain and Greece both had overall unemployment rates over 26%. Emerging markets weren’t much better, with growth forecasts for China and Brazil being cut and widespread protests in Brazil over government spending on the World Cup and the Olympics.

Manufacturing was inconsistent, contracting slightly in May and hitting its lowest point in four years although durable goods orders were positive in May. The trade deficit was up as imports grew at a faster rate than exports, although oil imports were the lowest since 1996. Consumer confidence, largely due to the highly visible housing market, hit a five-year high. Overall, first quarter GDP growth was revised downward from an increase of 2.4% to 1.8% as consumer spending was also revised to an increase of 2.6% (from 3.4%), health care spending was down and government spending was down over 4%. Consumer debt stayed calm, growing only for car loans and student loans.

The Fed gave the markets some early fireworks. Initial optimism about ongoing stimulus drove the stock markets up and the benchmark 10-year Treasury yield down. The Fed noted that stimulus may be adjusted as the job market developed but tax increases and federal budget cuts were “restraining growth”. Fed meeting minutes released just a few weeks later, however, indicated that some members wanted to begin tapering bond purchases in June and the market reacted swiftly, despite Bernanke’s assurances earlier in the same day that easy money would continue. In June the Fed further indicated that the risk to the economy and jobs had eased but they would keep buying, although they could start to wind down later this year. Confusion and speculation reigned and the damage was done, with the benchmark Treasury hitting a nearly two year high and investors dumping income investments.

Looking Forward

We’re not quite back to the rock-star days of Alan Greenspan when the media would look at the thickness of his briefcase to guess how the Fed would move on interest rates. But we are at the point where observers react immediately to anything the Fed or Ben Bernanke says, or what they think was said, and then react again when they take the time to digest what was actually said. Yes, such is the incentive for traders to be first that markets can move, and dramatically, on an interpretation of a seemingly innocent statement. The recent increase in interest rates is a reminder that while the Fed sets targets for very short-term interest rates the market and its expectations set all other rates.

To some extent the Fed brought this on themselves. Fed statements were historically intentionally vague as to the future intentions of the Fed. This gave the Fed the opportunity to adjust their actions as the economy developed. In the depths of the financial crisis, though, the Fed began to assure the markets that they were willing to continue low interest rates for as long as necessary. The use of various quantitative easing programs, which involved the purchase of bonds, also committed the Fed for specific periods. And, as recently as this year, the Fed indicated interest rates would be kept low until late 2014 or early 2015.

It was always assumed that interest rates would go up when the Fed stepped back. And it’s certainly not that the economy is so strong that the Fed needs to raise interest rates to slow growth. The economy may, however, be reaching the point where it can stand on its won without the artificial support of the Fed’s activities. It remains to be seen whether the Fed will back off before their previously stated time frame.

Our Portfolios

It’s fairly common that we can see well in advance that something is going to happen but we are still surprised or dismayed when it actually does happen. There have been plenty of warnings that investors who were searching for yield were getting themselves into investments they did not understand and they might not be aware that these investments would suffer if interest rates went up.

The benchmark 10-year Treasury went for 1.63% in early May to 2.59% in late June, contributing to the stock market decline. But income investments fared even worse. For example, an index of real estate investment trusts (REIT’s) fell 17% compared to the S&P 500’s 6% before both recovered somewhat by the end of June.

These investors are overlooking two basic points. First, if an investment is bought for the right reasons in the first place, short-term volatility should not matter at all. Again using REIT’s as an example, an investor should be interested in reliable income with the potential for a long-term increase in value at roughly the rate of inflation. The abrupt decline did not change these fundamentals. Second, investors conveniently forget that these income-oriented investments had increased in value far more rapidly than normal prior to the decline. REIT’s were up 30% in the two years before the decline, well above their 20-year average of 9%, which includes both the financial crisis and the recovery.

We are only using REIT’s as an example here; this is not to say that REIT’s are for everyone, or are even necessarily a great investment. It does, however, vividly illustrate that a properly constructed, diversified portfolio can practically eliminate the anxiety of short-term developments. It is important to recognize fundamental risks such as the impact of rising interest rates, but it does not mean that the mere existence of these risks should derail the pursuit of long-term investment objectives.

Bringin’ Down the House?

As noted in the quarterly summary, housing has become a bright spot in the economy. Homebuilder optimism is at its highest level in years and rising prices have lifted many homeowners from being “underwater” to the point that they no longer owe more than their house is worth. It is also fair to say that the housing market has become a “normal” market in the sense that if an item for sale is priced properly, there is enough demand that it will likely sell. This equilibrium is a big improvement from market conditions a few short years ago in which there were often no buyers regardless of price.

Of course, markets are very dynamic and opportunities change very quickly. As a case in point, here’s the first line of a CNN Money article from June 28 – “With mortgage rates rising at a record rate, it’s become a scary time for mortgage shoppers.”

The danger is that even a modest increase in monthly mortgage costs could derail the housing recovery. Average rates on 30-year fixed mortgages increased from 3.4% in early May to 4.5% by the end of June. That increase in only two months would cost an additional $126 per month on a $200,000 30-year mortgage. Not surprisingly, mortgage applications fell 3% in the last week of June and refinancing applications are down more than 30% since the start of May.

Financing costs are certainly a factor in buying a house, but the headlines are another example of exaggerating a specific set of circumstances. Yes, mortgage rates are up but that 3.4% in early May was near the all-time low rate; mortgage rates were at 4.5% as recently as two years ago and only dropped below 5% in early 2009. Before that mortgage rates were on a long steady decline from the brutally high rates of the early 1980’s and were still above 7% until 2002. The housing affordability index (an index of 100 means that the median family income has 100% of the income necessary to afford the median-priced house with a 20% down payment) hit a high of 210 in January, 2013. Higher rates have brought that index back to 180 but it was at a recent low of 100 in 2007, its lowest point since 1991.

As the saying goes, all real estate is local, and local housing markets are very different. There are plenty of markets where buyers still have the upper hand, while areas like Phoenix and Las Vegas have shown strong price increases and low supply as institutional investors have bought homes in bulk to create rental properties. Here in Tucson recent sales data show that existing homes that have sold have done so at over 99% of their listing price.

Cynics would say that if the recent increase in mortgage rates price a buyer out of the market, that buyer has no business buying a house at that price anyway. If anything, higher mortgage rates may slow the increase in home prices. But with inventory of both new and existing homes for sale well below the six-month norm, the increase in rates is unlikely to completely chill the market. And it would be a positive impact if the criteria for buying a home returned to one that fit a family’s needs and which the family can afford. It really shouldn’t be any more complicated than that.