The Market, The Fed and a Balanced Portfolio
The Dow Jones Industrial Average has slowed its recent advance and stands at 20,899 after recording a high of 21,115 on March 1st. The likelihood of a 3% to 5% stock market decline is present and would be quite normal after the recent advance. This would bring us back to the 20,000 level on the Dow. In addition to the usual advance and decline within market cycles, we have entered a wait and see period with respect to corporate tax policy, health care legislation and trade policy to name a few. As we have mentioned before, regardless of whether news or policy is viewed as good or bad, it is uncertainty that will slow the markets. Even negative items when known allow businesses to budget costs and forecast revenue.
In economic news, the Federal Reserve Open Markets Committee, the Fed, led by Janet Yellen has raised the Fed Funds rate .25% to 1.00%. The expectation is that the Fed will raise rates two more times in 2017 to 1.50%. The Federal Funds Rate is the overnight rate at which banks will lend each other money to meet the minimum reserve requirements required by law. Banks are required to keep a certain percentage of customer funds in reserve and since their goal is to keep these reserves working, they stay close to this ratio and if they fall below, will borrow money to meet the minimum requirements. While only an overnight rate, it can act as a benchmark for rates across the markets.
One aspect of the Fed mission is to moderate inflation and one tool is management of the fed funds rate. If the economy heats up and begins to grow too fast, triggering rising prices for goods and services, the Fed will raise rates making it more expensive to borrow money thereby slowing the economy. Conversely, when the economy weakens as in 2008, they will lower interest rates to encourage borrowing and stimulate the economy. While these examples are textbook explanations, history is full of periods that skew the norm such as the late 1980's where the market experienced 20% rates.
The Fed Funds rate has been effectively at zero since the mortgage crisis of 2008. This has been a most unusual period as the rate has never been at zero and moreover at zero for eight years. A normal target for rates is about 3.5% to 4.5%. Since there is no discernable rise in inflation at present, the concern for our portfolios is the effect of navigating the uncharted waters of normalizing rates and specifically the impact on our bond and fixed income positions. Further, should the economy start to strengthen, rising rates could slow the economy too early in the growth cycle.
A second tool for the Fed is the use of monetary policy and a concern that is increasingly discussed in Wall Street research is the status of U.S. debt held by the Federal Reserve. Since the mortgage crisis in 2008 the Fed's level of U.S. debt exceeds $2.5 trillion mostly in the form of U.S. Treasuries and Mortgage-Backed securities. This was done in the form of quantitative easing at various times, better known as QE 1, 2 and 3. As with lowering interest rates this was intended to spur economic growth yet this artificial stimulus produced a top GDP, Gross Domestic Product growth rate, of only 2.6% in 2015 which was a high for the period. The 2016 GDP growth rate was 1.6%. We believe a GDP growth rate of 3% to 4% is desirable.
As investors, we purchase these types of securities for either growth or income. The Fed purchased them for economic stimulus so the question for our portfolios is how we are impacted as the Fed must unwind their debt by selling these securities in the markets. Keep in mind that the U.S. government has a total outstanding debt of $20 trillion dollars.
It is often stated that the government is printing money in excess to facilitate these purchases. Note that that the federal reserve is a private corporation, not a department of the federal government which is a topic for later discussion. There is no need for ink and paper to add to our money supply to increase our debt. In 2012, then Fed Chairman Ben Bernanke stated "Now, you might ask the question, well, the Fed is going out and buying 2 trillion dollars of securities – how did we pay for that? And the answer is that we paid for those securities by crediting the bank accounts of the people who sold them to us..." The bottom line is that a simple accounting entry is all that is needed to accumulate trillions in debt.
How does this impact our portfolios? While the stock market has advanced, bonds have declined. They have an inverse relationship with each other similar to a see-saw: stocks up / bonds down and vice-versa. The see-saw analogy also applies to bond prices and bond yields which include dividends and interest. When bond prices decline, the current dividends and interest increase and vice versa. In a well-balanced portfolio, we will have a diverse set of securities that will complement each other in various market environments - not days, weeks or months - but longer market cycles. Rather than have a collection of stocks, bonds or funds, we prefer a portfolio of securities designed to complement each other in varying market environments. We rebalance our portfolios based upon market conditions and not an arbitrary date such as the beginning of a calendar quarter as is prevalent in the financial industry. Nor will we typically do a complete rebalance unless we feel it is appropriate but selectively rebalance per our view of the markets going forward as it relates to our asset allocation.
Almost all the securities used in Affinity Capital portfolios are commission-free. Any commissions, which are normally $6.95, are charged by our clearing firm Charles Schwab and not paid to Affinity Capital. Our rebalancing process is based upon percentage weights in the portfolios. For example, a position may have a desired weight of 5%. Yet if it declines to 4% we may purchase an appropriate number of shares to bring it back to our desired level. Conversely, if the position advances to 7%, we may sell 2% to bring it back to our desired weight. We work off percentages and the number of shares may be small but with the lack of commissions it allows us to be precise in managing your wealth. Additionally, we make every effort to be as tax efficient as is practical.