First-Half Report Card: Modest Gains, Murky Outlook

It's hard to describe single-digit first half returns as a raging bull market, but it's also hard to feel too negative about a six month period when the S&P 500 recorded 22 record highs and virtually everything in your portfolio--including bonds--rose in value. 

The Wilshire 5000--the broadest measure of U.S. stocks and bonds--rose 4.83% for the second quarter--and now stands at a 6.96% gain for the first half of the year.  The comparable Russell 3000 index gained 4.88% in the second three months of the year, posting a 6.94% gain in the first half of 2013.

The other U.S. market sectors experienced comparable gains.  Large cap stocks, represented by the Wilshire U.S. Large Cap index, gained 5.12% in the second quarter, and is now up 7.17% so far for the year.  The Russell 1000 large-cap index returned 5.12% for the quarter, up 7.27% for the year, while the widely-quoted S&P 500 index of large company stocks gained 4.69% for the quarter and is up 6.05% since January 1.

The Wilshire U.S. Mid-Cap index index rose 4.50% in the second three months of the year, and is up 8.42% at the year's midway point.  The Russell midcap index was up 4.97% for the quarter, and now stands at a 8.67% gain so far this year.

Small company stocks, as measured by the Wilshire U.S. Small-Cap, gained 2.71% in the second quarter; with the first quarter gains, the index is up 5.35% so far this year.  The comparable Russell 2000 small-cap index was up 1.95% in the second three months of the year, posting a 3.19% gain in the year's first half.  The technology-heavy Nasdaq Composite Index was up 5.94% for the quarter, and is up 5.30% for its investors so far this year, reaching levels that haven't been seen since March 2000.

The rest of the world is not doing as well.   The broad-based EAFE index of larger foreign companies in developed economies rose 2.95% in dollar terms during the second quarter of the year, and is up the same 2.95% so far this year.  The stocks across the Eurozone economies rose 1.90%, and are now up 3.45% for the first half of the year. 

The news was much worse for emerging markets stocks, which have been touted as the world's engine of growth.  The EAFE Emerging Markets index of lesser-developed economies rose 5.64% for the quarter, and are now up 4.80% for the year.

Looking over the other investment categories, real estate investments, as measured by the Wilshire REIT index, rose 7.47% for the quarter, and is standing at a remarkable 18.36% gain for the year.  Commodities, as measured by the S&P GSCI index, rose 2.69% this past quarter, posting a gain of 5.71% for the year.

Most market participants and pundits expected bond rates to rise in the first half of the year, but once again bond returns surprised the experts.  The Bloomberg U.S. Corporate Bond Index now has an effective yield of just 2.90%, while comparable yields in the Eurozone stand at 1.64%.

Treasury rates took their biggest first-half drop since 2010.  30-year Treasuries have seen their yields fall to 3.36% in the past six months, and 10-year Treasuries currently yield 2.53%.  At the low end, 3-month T-bills are still yielding a miniscule 0.04%; 6-month bills are only slightly more generous, at 0.06%.

One of the most interesting questions batted around among professional investors these days is: are these low yields sustainable in the future?  Can they keep dropping?  Won't the appetite for Treasuries finally dry up, forcing rates higher?  If you look at Treasury rates in isolation, current rates seem to be as low as they can go.  But it is also interesting to look at the global bond markets from an international investor's perspective.  Would you prefer to invest in U.S. 10-year Treasuries at 2.53%, or buy comparable Japanese government bonds, yielding just 0.563%.  Are you more attracted to German 10-year bunds, trading at 1.25% yields?  As little as they are yielding today, U.S. government bonds are still pulling in buyers from around the world, both as a safe haven and as a source of higher yields.

But depending on where you look, the economic news has been somewhat scary.  The U.S. economy's GDP dropped 2.9% in the first quarter of the year--an enormous hit which has been largely blamed on the weather.  The uncertainty in Iraq, including the recent ISIS capture of a major refinery, has sent the spot price of oil above $107 a barrel on global markets.  Manufacturing activity fell in the past month, and the growth of jobs, which looked promising last year, has slowed down, with the unemployment rate stuck at 6.3%.

There are also positive signs, particularly in the statistics for housing demand.  The pending home sales index for contracts to purchase previously-owned U.S. homes rose 6.1% in May, the largest advance since April 2010, when sales were boosted because the homebuyer's tax credit was on the verge of expiration.  The rise in the overall REIT index suggests a strong bounceback in the real estate industry overall. 

Even the government seems to be getting its books back in balance.  You won't read about it in the newspapers, but the U.S. federal deficit has fallen from $1.4 trillion to around $400 billion in the space of one year.  And the U.S. is now close to energy self-sufficiency, which means that the trade deficit (which has been largely driven by the cost of importing Middle Eastern oil) is shrinking dramatically vis a vis the rest of the world. 

The Michigan Sentiment Index recently hit 82.5, which means that people are generally optimistic about the state of the economy and the world.

Where do we go from here?  The future is never clear, but today it might be less clear than usual.  The long bull market that started in March 2009 and the economic expansion that started nearly at the same time are both among the longest since the Civil War.  Bull markets have to end eventually; we all know that.  However, this growth period has been more like a marathon than the usual recovery sprint after a recession; the economy has grown at a 2% annualized rate since 2009, which is below the long-term average, and considerably below what is normal during a recovery from economic malaise.  Marathon runners--at least in theory--can keep moving longer than sprinters.  Is that the case today?  The U.S. Federal Reserve has vowed to keep interest rates low for the next 12 months, and many investors seem to be comfortable with with this approach, believing it could be a recipe for more economic growth, profits and clear stock market sailing in the foreseeable future.

The truth is, none of us can tell whether the markets will continue to test records or not.  The best indicator, and it is not something you can pin down, is whether people are still anxious about the future and concerned about the possibility of a market plunge.  So long as people are still worried, the market probably hasn't reached its top.  Whenever you see most investors finally deciding that the market is on a permanent upward climb, whenever everybody finally gives up on worry and puts their money into the hot market, that is when stocks have probably peaked, and an unpleasant surprise awaits those who joined the party too late.

Where are we on this scale?  Few investors seem to be enthusiastic about current market valuations, which some believe to be a bit overpriced.  At the same time, the sentiment surveys are in the "complacent" zone, and we are not hearing quite the same shrill tone from perma-bears and pundits who probably feel a bit embarrassed about predicting disaster over and over again as the markets sailed through scary headlines and economic headwinds.

This may be the perfect time to celebrate the fact that we've managed to stay invested during fearful times, when government shutdowns, European banking crises and the threat of another meltdown at home were driving others away from the improbable upward trend.  Since 2009, only the brave have stayed the course, and they earned the rewards of what, in retrospect, has been one of the most generous bull markets in U.S. history.  How much more is in store for them, or when the inevitable pullback will come, is not something we mortals are given to know--despite the loud predictions you will hear from economists and pundits whose crystal balls are no more clear than yours.

Food Price Crisis?

If you've visited the grocery store this year, you know that food prices have been going up alarmingly in recent months--and, in many cases, the price increases actually started years ago.  Bacon prices (average $5.55 a pound) have risen 53% over the last four years, joining margarine ($2.11/lb, up 30%), ground beef ($4.13/lb, up 35%), oranges ($1.21/lb, up 35%), coffee ($5.00/lb; up 31%) and peanut butter ($2.71/lb, up 30%) as food commodities that have seen their prices rise by roughly a third over the past 48 months. 

Some specialty items have gone up even more.  If you had invested in a warehouse of fresh pine nuts four years ago, you'd be able to retire comfortably today.

The question we should be asking ourselves--especially those of us who expect to rely on fixed income in retirement, is: is this trend going to continue?  Are food prices headed ever higher?  And if so, should we be adjusting our budgets for double-digit annual inflation at the dinner table?

As it happens, we are living in a perfect storm, where supply shortages have been caused by forces over which farmers and ranchers have very little control.  The biggest culprit is the multi-year drought in much of the western U.S.  California is in the midst of its longest--and worst--drought on record.   2013 was California's driest year on record, and a freak heat wave during this year's rainy season has put 2014 on track to break that dismal mark.  Farmers in the most productive agricultural land on Earth--California's central valley--have cut back on the number of acres planted as the snow pack in the Sierra Nevada mountains remains at roughly 15% of normal.  This matters to food consumers everywhere.  California produces a huge percentage of the nation's celery (95%), avocados (90%), cauliflower (89%), lemons (83%), spinach (83%), carrots (66%), broccoli (94%), strawberries (88%), bell peppers (50%) and tomatoes (30%).

The same drought pattern also extends deep into Texas, New Mexico, Oklahoma, Kansas and Nebraska, which have forced many of the nation's most productive beef cattle and feed growers to pare back herds and acreage.  At the same time, Florida's citrus growers are facing a deadly new disease called "citrus greening" that has devastated orange groves--and for which there appears to be no cure.  A relatively new hog virus called Porcine Epidemic Diarrhea Virus has significantly cut into pork production.  And coffee prices have exploded ever since a fast-spreading fungus infection has begun spreading across farms from Mexico all the way to Peru.  Hardest hit are the so-called "arabica" coffee plants, which produce the beans used in espressos and gourmet specialty coffee blends.

Normally, you hear commentators talk about commodity cycles, where higher prices in one year give farmers an incentive to plant more acreage, which means they produce more in hopes of taking advantage of those high prices.  The excess supply drives prices back down toward normalcy.  If prices are low, farmers cut back on acreage, and the lower production causes prices to rise back toward more normal levels.  Some analysts are trying hard to explain why these time-honored mechanisms seem to have failed us over the past four years.

The answer is simple: the current situation is out of the control of farmers.  Because of the unpredictable dynamics caused by Mother Nature, and the sudden advent of new crop diseases, food prices might stay high for at least a few more years--and they will be harder to predict as a retirement budget item.

Are Daughters a Better "Investment?"

As Father's Day passes, a new survey from the online account aggregation firm Yodlee.com and Harris Interactive tells us that the financial relationship between fathers (and parents) can be very different for their sons vs. their daughters.  The survey found that an astonishing 75% of young adult men (age 18-34) are receiving financial aid from their parents, compared with 59% for comparable age daughters.  The financial dependency extends deep into adulthood; among sons aged 35-44, fully 32% are still living at home, while only 9% of women in that age bracket sleep in their former bedroom.  Even those numbers understate the disparity, because more than a third of the women who are living with their parents are doing so to support them in old age, something that sons are, according to the report, far less likely to do.

Overall, daughters are 32% less likely to need their parents' money, and twice as likely to move back home because they're unemployed.  By age 45, the survey found, most of these stark differences in financial independence have faded; sons lag only a few percentage points behind daughters in these two areas.  But then a new discrepancy emerges.  The survey found that older sons are half as likely as daughters to support their parents in old age. 

60 Minutes - Michael Lewis - The stock market is rigged!

What??!  The Stock Market is Rigged???

You may have heard about the 60 Minutes interview with author Michael Lewis, a former Wall Street broker, author of "Liar's Poker" and "The Big Short," who has just come out with a new book entitled "Flash Boys."  Lewis is an eloquent and astute critic of Wall Street's creative and predatory practices, and in his new book (and in the 60 Minutes interview March 30, 2014) he offers evidence that the stock market is "rigged" by a cabal of high-frequency traders, abetted by stock exchanges and Wall Street firms.

The charge is entirely true.  And it is also completely irrelevant to you and anyone else who practices patient investing.

Lewis is exposing a secret advantage that a surprisingly large number of professional traders, employed by large brokerage firms, are able to get when they build high-speed fiber optic cable feeds directly into the computers that match buyers and sellers of securities.  Some of those traders actually have their trading computers located in the same room as the New York Stock Exchange and Nasdaq servers.  And some pay extra for access to more information on who wants to buy and sell, more quickly, than would be available to you if you were sitting down at your home computer looking to buy or sell Apple Computer through a discount brokerage account. 

All of this is perfectly legal, but Lewis points out that it is also shady.  Why should some buyers and sellers have millisecond advantages over others?  The companies that see more of the market, more quickly, are able to jump in ahead of you and me and buy stocks at lower intraday prices, and then jump ahead 15 seconds later and sell to the highest bidder before you and I would even see that bid on our screen.  They can buy the stock you put in an order for and sell it to you at a fractionally higher price through the normal market-matching mechanisms.  This way, they can squeeze out additional pennies and nickels on each transaction, and if they do this thousands of times a day, it adds up to real money--millions of dollars a year.

Why is this irrelevant to you?  Many of those lost dollars are coming out of the pockets of day traders, ordinary people who are foolish enough to think that they can outwit the markets by moving into and out of individual stocks several times a day, or professional traders at hedge funds who may not have access to the fastest server or a direct feed into the Nasdaq servers.  There are tens of thousands of these investors, and many of them, watching the 60 Minutes report, discovered for the first time that they are getting routinely fleeced by Wall Street's money machine. 

However, if you're invested for the long term, it really doesn't matter how many times the stocks you own inside of a mutual fund or ETF, or directly in your retirement account, change hands or at what price every few minutes.  It doesn't even matter whether your stocks are up or down in any given month or year, so long as the underlying companies are building their value steadily over time.  Your time frame is eons compared with the quick-twitch traders, who hope to be in and out of your stock in minutes rather than decades.  Your mutual fund that buys when a stock seems cheap might, if it's careless or unsophisticated, give up fractions of a cent on its purchases, but that likely isn't going to have a measurable impact on your long-term investment returns.

Somehow, this important fact was lost in the 60 Minutes interview.  The interview also didn't mention that things can go horribly wrong in the arcane and predatory world of rapid-fire trading.  The Hall of Fame of trading losses includes $9 billion lost in credit default swaps by a single Morgan Stanley trader from 2004 through 2006, or the $7.2 billion lost by Societe Generale trader Jerome Kerviel over a few days in 2008, or the $2 billion "London whale" losses in 2012.  They--and many others--used their milliseconds speed advantage to generate staggering losses, proving that even the smartest operators aren't always raking in the profits.

In the end, the interview tells us several things.  First, it exposes, yet again, the fact that the Wall Street culture will go to great lengths to grab money out of the hands of unwary investors.  One wishes that the 60 Minutes interviewers had asked a simple question: what economic purpose is served by fast-twitch traders, trying to make money for their wirehouse employers by purchasing and selling individual stocks multiple times a day ahead of other investors?  Is this benefiting the economy in some way?

Second, the interview makes plainly clear the folly of an average investor trying to outsmart the markets with short-term trading activities. 

And finally, for those who can see the big picture that is never explained in the 60 Minutes interview, these revelations confirm the wisdom of having a long-term investment horizon.  When you measure returns over three-to-ten year time horizons, the milliseconds don't matter.

However, I have bought and am reading the book!