The Markets	06/30/14 Close	03/31/14 Close	2nd Qtr. Change	06/30/13 Close	12 Mo. Change	YTD Change
Dow	16,827	16,458	+2.24%	14,910	+12.86%	+1.51%
NASDAQ	4,408	4,199	+4.98%	3,403	+29.53%	5.53%
S&P 500	1,960	1,872	+4.70%	1,606	+22.04%	+6.06%
MSCI EAFE	1,972	1,916	+2.92%	1,639	+20.32%	+2.92%
10-yr Treas. yield	2.52%	2.72%	-0.30%	2.48%	+0.04%	-0.51%
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)

Global stock markets eked out somewhat better gains than in the first quarter, with the Dow and the S&P 500 hitting a series of incremental all-time highs. Interest rates continued to drift back lower, and during the quarter the benchmark rate broke out of the tight range (2.60% to 2.80%) it had been in since mid-January. To the surprise of most, it broke out on the downside rather than on the upside. Of greater concern (or at least confusion), stock market volatility has all but dried up and the S&P 500 has not had a correction (typically defined as a short-term drop of 10%) for more than two years, an unusually long period. The euphoria is causing many to wonder if we are in the calm before a storm.

The housing market continued to stabilize, if not fully recover, although market strength varies widely across the country. Pending home sales for May hit a six-month high, the annual increase in new home sales was the best in six years, inventories of new homes is low and median prices for both new and existing homes were up 5% to 7% from a year earlier. Consumer spending rose in two of the three months and income growth was moderately positive. Overall, consumer confidence hit its highest level in six years.

After hitting a seven-year low in early May, new weekly jobless claims settled in a tight range around 315,000 and the economy added more than 200,000 jobs for four straight months, the first time since 2000. Job openings in April were nearly 4.5 million, the best since August, 2007. The 8.7 million jobs lost during the recession were finally recovered, but during the same period the working age population increased by 10.6 million and 12.8 million workers dropped out of the workforce.

The broad Purchasing Manager Index for manufacturing had its best overall quarter in four years and the June service indicator was the best in 4 ½ years. New factory orders were up consistently but capacity utilization is still under 80%, indicating further room for additional production. Auto sales climbed to a nine-year high in May and an annual level of 16.5 million vehicles. Core capital goods, a proxy for business investment levels, returned to an increase of 0.7% in May after a 1.1% decline in April. The income inequality debate stayed on center stage as Seattle passed legislation for the highest minimum wage in the country by phasing in to $15 an hour over the next three to seven years, depending on business size.

Central banks were busy during the quarter. The Fed steadily tapered its bond buying and is now down to “only” $35 billion a month. The Fed noted that capital investment needs to increase and that rates will be kept low even after the taper is completed. May euro zone inflation of only 0.5% sparked fears of deflation and spurred the European Central Bank into action. The benchmark short-term interest rate was lowered to 0.15% from 0.25% and the overnight deposit rate for banks was moved to -0.1% from zero. That means it actually costs banks to keep money in overnight central bank deposits, so the move is intended to motivate banks to put more money into the economy. Interestingly, after five years of turmoil, Greek GDP is finally rising, deficits are falling, government bond sales are brisk, bond yields have fallen dramatically and the Greek stock market is up 82% in the last two years.

While slow growth continues, a number of forecasts were changed. The World Bank lowered its 2014 global forecast to 2.8% growth from 3.2% because of the US winter and the disruption in Ukraine. The International Monetary Fund cuts its US forecast for 2014 growth from 2.8% to 2.0% but also projected full employment by the end of 2017. The final first quarter GDP was reduced to a drop of 2.9% from the prior estimate of a 1.0% decline (and an initial estimate of a 0.1% increase), although the change was seen as temporary and offset by other positive indicators.

Looking Forward

Over time, interest rates have been a frequent subject of Looking Forward, which is quite remarkable considering they have been so low for so long. That is partly due to the intricacy of monetary policy and partly due to the frustration that those low rates have not spurred the economy as hoped.

But we now find ourselves within sight of the end of quantitative easing, and if the Fed stays on schedule as expected their bond purchases will stop in September. Despite the Fed’s insistence that they will keep rates low well beyond the end of easing, there is a mounting cry that rates will rise sooner than the Fed would like. Keep in mind that the Fed can directly influence only short-term rates and other rates are driven by market forces. The mysterious market is said to try to predict six months out, so even if the Fed stays with its schedule the market could start to move rates by the fall. As we saw in May and June, 2013, the pace of a rate change can be as or more traumatic than the change itself. Once rates start to creep up, it may be wishful thinking that it will be rational and orderly.

Oh, and don’t forget that downward revision for first quarter GDP. In addition to the harsh winter weather, the decline was largely blamed on a reduction in health care spending from prior estimates. The winter has passed and spring and summer weather should be better for the economy (who cares about those pesky hurricanes, tornadoes and wildfires?).

Health care spending is another of those short term/long term quandaries. Of course, a slowdown in health care spending and costs is a good thing, as long as health outcomes are maintained (and hopefully improved). Everyone agrees that the rate of increase in health care costs is unsustainable. But the transition to lower spending could have a temporary effect on growth until the economy has a chance to adjust. The second quarter GDP results are expected to show growth of 3% or more and will answer the weather question. The rest of the year may confirm a trend in health care spending and costs.

Our Portfolios

In the review for the fourth quarter of 2013, we talked about the challenges of investing when almost assets seem expensive. Then we dismissed the idea of making a big swing into whatever assets had underperformed, in favor of staying with long-term diversification.

At the recent conference of Morningstar, the well-known investment research and information company, many fund managers expressed concerns across the board. Treasury bonds are still vulnerable to interest rate increases, corporate and mortgage bond prices have gone up to the point that they are not paying enough of a premium to risk-free Treasuries and stocks are at lefty levels by most measures. Cash provides some protection against loss, as always, but investment managers are hired to invest, not hold cash.

Despite that, some high-profile bond fund managers are so concerned that they are holding up to 60% of their funds in cash. They hope to avoid the losses and market panic if rates do go up, and then step in and buy bonds at significantly lower prices. At the same time, other bond managers are looking to emerging markets like Poland and Hungary to benefit from continued stimulus from central banks worldwide.

In stocks, there’s a slight majority, but not universal, view that European stocks offer better value than US stocks. Other managers see large Japanese companies as relatively cheap. Along the way, the US market has squeezed out a series of new highs.

This is all very interesting, and we do keep an eye on the managers of funds that we use to complement the broad index funds in our portfolios. With the possible exception of Oakmark International (a fund that owns around 50 stocks and holds them for a long time, with little short-term trading), we avoid funds that would be considered “big bet” funds or funds that regularly change their stripes.

Make no mistake about it, we find plenty to be concerned about in the current market environment, but we constantly remind ourselves and our clients that we are looking long–term and are relying on that diversification to both allow the portfolios to participate in gains but to also cushion losses. And there remains a fundamental difference between investment managers whose sole focus is their particular investment mandate and financial planners who use investments as one of many tools to do their job.

Hedge Trimming

We have often criticized hedge funds as being overpriced, opaque and grossly overhyped – in most ways built for the benefit of the hedge fund manager at the expense of the gullible investor. Those criticisms could be dismissed as the “sour grapes” of people who are just envious of the wealth of hedge fund managers and who just don’t understand how the world of high finance works.

Fair enough, but there is also plenty of evidence that these criticisms actually aren’t harsh enough. Simon Lack, a New Jersey asset manager and a former member of JP Morgan’s hedge fund due diligence team, published The Hedge Fund Mirage in 2012 and updated his analysis through 2013.

Lack says that in the 1990’s the hedge fund industry was small, the number of investors was likewise small and returns were strong in relation to other investment approaches. In the mid-2000’s hedge funds changed from serving private banking, high net worth clients to courting institutional investors like endowments, foundations and pension plans. As a result, assets in hedge funds have exploded, fees are far too high and hedge fund managers have convinced investors that there should not be transparency so proprietary information can be protected. In other words, don’t ask what the fund is doing, just trust them.

Lack analyzed hedge fund data for all the funds he could (about half of all funds) from 1998 to 2013, when hedge fund assets grew from around $200 million to over $2 trillion. For that period only 7% of all funds fell in the top 40% of returns for every year of the study. That means that funds gravitate to “average” performance over time, and using multiple hedge funds only strengthens mediocrity.

Lack’s data included funds that liquidated during the period and excluded returns generated by managers before their funds accepted outside investors. By doing so Lack presents a more complete and accurate picture and exposes the industry’s typical approach of conveniently dropping bad numbers and sweeping in good numbers.

From 1998 to 2013, hedge funds had cumulative profits of $596 billion. Because hedge funds charge high fees even in years with investment losses, total fees were $566 billion. That left investors with only $30 billion over the period, a little over 10% of the cumulative profits.

Performance paints as bleak a picture as fees. Until 2002, when hedge fund popularity exploded, returns were strong. Since 2002, a 60% stock/40% bond portfolio has outperformed hedge funds every single year. Even worse, hedge funds overall have only earned 7% (a typical target return for institutions) once, in 2009.

If hedge funds fool you once, shame on them. If hedge funds fool you twice (or three or four times, or for ever larger amounts of money), shame on you.