Outlook May 2006

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Recently, I received a letter asking for advice on whether an investor should sell a particular bond fund and reinvest the money in an appreciating stock fund. Questions like that are unanswerable without comprehensive financial planning, but I suspect the answer should be to keep the bond fund.

Over the past year, rising interest rates have caused bond prices to fall. As a result, bonds have slight capital losses. Since they have paid more interest than these losses, they have still made a profit. Although we have avoided a bond bear market, bond returns have been poor.

But as bond prices have dropped, their effective yield for new investment has risen. Bond prices are now the highest they have been in 4 years. Yield on the 10-year bond reached 5.12%, the highest since June 2002. Even the money market, which many need to be reminded is an asset class itself, is paying better rates of return at 4.6%.

The Federal Reserve has raised interest rates 0.25% for 15 straight meetings, bringing rates back to 4.75% after hitting a low of 1% in the spring of 2004. But recently, Fed members have indicated that rate hikes are near the end.

In recent months, rising interest rates have caused the housing market to slow. So far, the housing market deflation has been little more than a sigh of relief that markets are returning to normal. With more houses on the market and more houses staying on the market for longer periods of time, buyers have found some relief but are only now beginning to see the impact on sales prices.

Inflation continues to be a practical concern, but the methods used to measure core inflation have avoided those elements with the greatest price increases such as energy, healthcare, and college expenses.

The high cost of energy is not a political issue, it is an economic issue. Oil scarcity isn’t an Exxon-Mobil conspiracy to gouge the American people. It is a market reaction to the cause and effect action of supply and demand. Supply is diminishing and demand is surging. Higher oil prices will do more to conserve energy and develop alternative energy sources than all the political hand wringing in Washington D.C.

The high cost of energy has boosted the returns of hard asset stocks. Designating a portion of your asset allocation to hard asset stocks is important. In the right allocation, hard asset stocks help balance your bond portfolio and provide a smoother ride while invested in the markets. As bond prices have dropped, the rise in hard asset stocks helps balance your overall portfolio returns.

There may be a time when hard asset stocks will fail to do well. That will be the time that bonds are doing well again, and keeping the proper balance between these two investments will continue to provide better smoother returns.

Economic conditions are solid. Durable goods orders have been strong. The companies in the S&P 500 are posting their 11th straight quarter of double-digit earnings growth. Much of this positive economic news has been factored into the market with US stocks having a higher than normal P/E ratios. The short-term danger for US stocks is that economic reports won’t be as rosy as has been expected.

For this reason, we continue to believe that diversification into foreign stocks remains critical. On average, assigning the right asset allocation to foreign stocks decreases a portfolio’s volatility and increases its return.

I advised the reader who was considering switching funds that the bond fund they were currently invested in was a good fund. It was well-managed, kept expenses low, and produced a good return for the category of US bonds. If they switched, they risked moving out of the category of US bonds at exactly the wrong time.

In comprehensive financial planning, your asset allocation should be tailored to fit your financial goals and cash flow. Then, while monitoring your portfolio, rebalancing means selling what has done well and buying what has done poorly, not visa versa. This contrarian approach will save your portfolio from significant mistakes.

Photo by Rowan Heuvel on Unsplash

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David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. Favorite number: e (2.7182818...)