Client Letter – Q2 2012

During the past quarter, U.S. and international stocks were back in negative territory, with international and emerging markets down the most.  This quarter had a negative impact on our one-year returns, leaving only the S&P 500 and real estate in positive territory for the year.  The following chart shows the 1-year, 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, 2012

 DFA Fund / Index  1 Year Return  5 Year Return*  10 Year Return*
S&P 500 Index 5.45 0.22 5.33
DFA U.S. Large Value -3.20 -2.79 5.43
DFA U.S. Small -2.29 1.68 8.04
DFA U.S. Small Value -4.57 -1.62 7.82
DFA Real Estate (REITs) 13.06 2.30 10.25
DFA Int’l Large -13.89 -5.21 5.41
DFA Int’l Large Value -20.11 -7.57 6.71
DFA International Small -15.42 -4.23 9.96
DFA Int’l Small Value -17.54 -5.73 10.54
DFA Emerging Markets -14.96 0.70 14.85
DFA 5-Year Global Bonds 4.29 4.73 4.39
DFA Intermediate Gov’t Bonds 9.08 7.77 6.08

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

While the one-year and five-year returns for most equity asset classes are quite dismal, the ten-year returns for stocks still range between 5% and 15%.  Despite the poor performance of international stocks during the last year, their 10 years returns remain higher than U.S. stocks.  Short and intermediate bonds continue to remain steady with returns ranging from 4% to 9%.  Inflation adjusted bonds have been the star performer over the last 1-5 years, earning returns of 9% to 12%!  The key point to remember is that we cannot predict which asset classes will do well in the short term (e.g. any period under 15 years).  Therefore, we are best served by owning all of the major asset classes and rebalancing our portfolios to keep the risk levels consistent with our long term investment policy.

Economic turmoil in Europe, a slowing economy in China, and stubbornly high unemployment in the United States have scared a lot of investors out of the stock market. Each day new headlines detail slowing growth and economic problems. Yet it is times like these when investors must resist the urge to sell stocks in order to gain a false sense of security by holding assets in cash and bonds. In fact, now may be a great time to buy stocks for the long term (for those with money to invest). Stocks are relatively cheap compared to bonds. At the beginning of June, the 10-year U.S. Treasury yield was just 1.47 percent. The earnings yield on U.S. stocks was 8.95 percent. David Kelly, chief market strategist for J.P. Morgan Funds, recently wrote that stocks are cheaper compared to Treasuries than at the end of any quarter in almost 60 years. Meanwhile, Wells Fargo Advisors notes that the Conference Board’s composite of Leading Economic Indicators has increased by 1.92 percent through April. Since 1970 the index has increased at that pace eight times, and the average gain for the Standard & Poor’s 500 Stocks Index over the next year was 12 percent.

The Federal Reserve and its counterpart central banks in Europe and Asia have all turned on the money spigots over the past year, keeping interest rates at historic lows and supporting bond prices. Such actions in the past have always led to higher stock prices as both economic activity picked up and low interest rates made alternative investments unattractive.
Although inflation currently is very low, higher food and gas prices, coupled with the Federal Reserve’s pump priming operations, have some worried that we are headed back to the high-inflation days of the 1970s and early 1980s. Critics of the Fed and other big central banks say their attempts to create growth by flooding the world with cash at low interest rates will inevitably result in double-digit inflation. These worries are unfounded because the conditions for a return of high inflation do not exist right now, says the Vanguard Group’s chief economist, Joe Davis.

Inflation hit its highest levels of the 20th century during the presidencies of Jimmy Carter and Ronald Reagan. A sharp run up in oil prices during the Carter years helped to push inflation to just under 10 percent, followed by another run to over 11 percent during Reagan’s first term. The Federal Reserve Chairman under Reagan, Paul Volcker, raised short term interest rates sharply to slow the economy down, finally breaking the back of the inflationary spiral.
But times are different today, and economic conditions are not like they were prior to the inflationary 1970s and early 1980s, Davis says. There are five drivers of inflation: growth in disposable income (your take-home pay); growth in gross domestic product; the money multiplier, which measures how fast money moves around in the economy; home prices; and growth in bank credit. All of those measures are far lower today than they were prior to the two periods of inflation under Carter and Reagan. Home prices, for instance, are falling rather than rising at a 13 percent pace like they did in the early 1980s. Although the Fed has created a lot of extra money, banks are not lending and the money is sitting in bank reserves. Wages are stagnant, so there is no money to push up prices. Davis recommends a balanced portfolio of stocks and bonds to deal with moderate to higher inflation over time.

Thank you for your continued trust and confidence.  Do not hesitate to call me if you need to discuss something or you’re just worried about the markets—that’s what I’m here for.

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.