Client Letter – Q2 2010

During the past quarter, global stock markets ended their year-long rally and experienced their first major correction since the crash of 2008. Despite strong corporate earnings reports, global investors reacted to the European debacle, the Gulf oil spill, Goldman’s troubles with the SEC, and worries about a possible double-dip recession.  The following chart shows the 3-month, 5-year, and 10-year performance of many DFA funds (representing different asset classes) compared to the S&P 500 Index:

Market Returns for the period ending June 30, 2010

 DFA Fund / Index 3 Month Return 5 Year Return* 10 Year Return*
S&P 500 Index-11.43-.79-1.59
DFA U.S. Large Value-12.80-1.584.77
DFA U.S. Small-9.421.104.95
DFA U.S. Small Value-12.48-.668.31
DFA Real Estate (REITs)-3.93-.199.65
DFA Int’l Large-14.061.56.50
DFA Int’l Large Value-14.802.325.10
DFA International Small-10.693.157.61
DFA Int’l Small Value-14.132.549.78
DFA Emerging Markets-8.6712.5510.44
DFA 5-Year Global Bonds2.014.154.89
DFA Intermediate Gov’t Bonds4.475.997.20

*Note: Returns for periods greater than 1 year are annualized.  Top 3 returns are in bold.

As shown above, the only safe havens this quarter were short and intermediate term bonds. With the exception of real estate, every other equity asset class dropped at least 8% during the quarter.  However, you’ll notice that the 10 year returns of most equity assets classes still ranged between 5-10%.  The reason for the negative sentiment about the past decade comes from the poor performance of large U.S. stocks (S&P 500 and Dow indexes).  A well diversified portfolio should have performed fairly well over the last 10 years.

Because of the fears that so many investors have regarding the impact of current U.S. policy, a higher government debt burden, and increasing taxes, there has been a strong movement towards bonds and fixed income this quarter.  Investors who buy bonds today based on their long-term track records should be careful, though. Because of the dramatic change in interest rates over the last 30 years, the past for bonds is no prologue to the future. Because today’s interest rates are so low, investors would do best to stick to high quality, short-term bonds so they can ride out a potential coming interest rate storm.

The bond market has been a pretty good bet over the last 30 years, even beating stocks over certain periods. The Barclays Capital Aggregate Bond Index, a good benchmark for domestic bonds, ranged in yield from 7 percent to 10 percent during the 1970s, climbing as high as 15 percent in 1981. For the rest of the 1980s it yielded near 9 percent, and during the 1990s it ranged from 5 percent to 9 percent. But then came two back-to-back recessions in the last decade, and yields on the index fell to their current average of about 3.5 percent, the lowest in 40 years. Those low yields will make bond investing problematic going forward. Inflation, currently running at about 1 percent, could pick up in the next several years, meaning that the real return after inflation on the index will be close to zero. Even worse, if inflation picks up enough, it is inevitable that interest rates will go up. In that case the retail value of current bonds will fall, just as the prices of stocks fall in a bear market.

The only scenario that might make the current bond market attractive is another disastrous economic slowdown akin to the Great Depression. Such a slowdown would push yields further down and increase the principal value of current bonds. And this assumes you own relatively safe government issues; a depression could cause total loss for investors in the corporate bonds of companies that go bankrupt.

This doesn’t mean you shouldn’t invest in bonds: they are an integral part of a well-balanced portfolio and should always be included to some extent. It does mean that you should consider keeping the bulk of your bond holdings in shorter-maturity bonds, such as those that mature within a couple of years. Although they will have the lowest interest rates currently, they will not be hurt very much when interest rates rise. In a short-term bond mutual fund, for instance, the bond managers will be able to quickly replace them with new, higher-rate bonds, thereby making up for any temporary declines in principal value. It is also worth diversifying globally in a bond portfolio just as you would in a stock portfolio.  Bonds of other major developed countries may not be as prone to interest rate risk as bonds in the U.S.

Thank you for your continued trust and confidence.  As always, feel free to call or send an email if you need anything.

Sincerely,

Chris signature


About Christopher Jones

Christopher Jones is the Founder and President of Sparrow Wealth Management, a fee-only financial planning and investment management firm. Before entering the investment field, Chris was a management consultant for Deloitte Monitor. He graduated summa cum laude from Brigham Young University with a B.S. in Economics and a minor in Business Management.