Third Quarter Market Commentary

Equity markets finish third quarter strong

Equity markets reversed their August losses, moving sharply higher for September and for the quarter. The Dow Jones Industrial Average, posting its best September since 1939, was up 7.85 percent for the month and up 11.13 percent for the third quarter. The S&P 500 Index gained 8.92 percent in September and 11.29 percent over the quarter.

 The September gains moved both major U.S. indices back into the black for 2010, as the DJIA is up 5.57 percent and the S&P has gained 3.89 percent year-to-date. Markets reacted favorably to further speculation that the economy would not slide back into recession. Although recent economic data has been weak, the reduced threat of a double-dip recession put many market participants at ease.

 Overseas markets also rallied after the August slump, with most major markets again looking past lackluster economic data. The MSCI EAFE Index gained 9.80 percent for September and 16.48 percent for the quarter, as investors’ appetite for risk pushed markets higher. A taste for risk was particularly evident in the emerging markets, which were up 10.87 percent for the month and 17.16 percent for the quarter.

In the commodities space, investors continued to demonstrate an insatiable appetite for gold, based on concerns over currency devaluations and the potential threat of future inflation. In late September, gold closed above $1,300 an ounce for the first time ever, and investor interest went unabated. The spot price of gold, as indicated in Figure 1, has increased 18.91 percent year-to-date.

 

Figure 1. Gold Spot Price: April 2007–August 2010

Source: Bloomberg

 

Fixed income flows help support bond prices

Flows into fixed income continued at a record-setting rate throughout the third quarter, helping to support bond prices, while equity flows have been negative for six of the last nine months.

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Financial “Check ups” Vital to Long-term Financial Success

– Beyond cliché’s, such as “A penny saved is a penny earned” and “Waste not, want not,” what does it mean to be financially healthy?

“The simplest approach is to evaluate whether you live within your means,” said Andy Oakes, financial adviser for LeConte Wealth Management. “When clients come to us for investment advice, it’s a lot like going to the doctor. They ask questions like, ‘Am I financially healthy?  If not, how do I get well?  And, how do I stay that way?’”

To find out how to live within those means, Oakes suggests a monthly budgeting strategy. Budgeting is the monthly process of reconciling income and expenses.  No doubt a part of those expenses will include debt, like a car payment or mortgage.  A healthy budget limits debt repayment to one third of income.  For a family earning $5,000 per month, this would mean that their debt payments shouldn’t exceed $1,650 per month (Example could be a $900 mortgage, a $400 car payment, $200 in credit card bills, and $150 student loan payment).  That leaves two thirds (or $3,350) for living expenses, taxes and savings.

“Managing your monthly budget can be difficult and frustrating,” said Oakes. “One of the most important aspects of controlling your budget is to determine where your money is going.”

Click on the Calculators section under the Financial Planning tab for free financial tools and calculators.  The Home Budget calculator helps build a monthly budget.  By entering income and monthly expenditures, you can see how much is left to save and where your money is being spent.  In addition, you can click the "View Report" button to compare your budget breakdown to our targets, which can help identify areas for improvement.  Check out the Net Worth calculator to determine the value of all of your assets minus the total of all of your liabilities.

Financial health, like physical health, is not just about today; it is about tomorrow.

So what does “long term” mean exactly?  From a financial perspective, it means a goal that will require a substantial amount of money to fulfill a savings goal at some point in time, such as five years from now.  This is the hard part of budgeting, because it involves delayed gratification or paying for something today that may not seen for five, 10 or even 30 years.

Unfortunately though, most Americans are disconnected from how their savings are invested, and this puts their long-term financial goals at risk.

So, if you are doing the right thing by saving, how can you be a good steward with investing?  LeConte Wealth Management offers the following simple guidelines for creating a “purpose-built portfolio:”

  • Align. Investments should be aligned with your goals.  If your goal is to create retirement income, bonds paying regular interest may be considered as part of your portfolio.
  • Diversify.  Through exposure to different types of holdings, you may be able to reduce risk.  Investing in one stock is likely more risky than investing in one mutual fund that invests in two hundred stocks. Diversification does not assure a profit or protect against a loss in declining markets.
  • Monitor.  Periodically check your progress to ensure that you are on track to achieve your goals and that what you invest in is performing in line with the overall investment markets.
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The Smart Way to Cash Out

Retirement is suppose to be the time when you check out of the rat race, throttle your stress level down and pursue all of the things that you deferred during your working years. You’ve educated the kids, paid the mortgage off and saved enough to fund your golden years. Now, it’s time to collect your gold watch, stop worrying and start enjoying life.

Does your retirement reality look anything like that description? If it does, I’ll wager that you retired more than 15 to 20 years ago. If you retired in the last decade or you plan on retiring in the next decade your retirement years will be dramatically different. Do you know why? Our more senior generation of retirees likely enjoyed long careers at their company and they retired in an era that provided them with a company funded pension. Recent and future retires face the daunting task of replacing these disappearing company-sponsored pensions with a home-grown retirement income plan of their own design. Our government has tried to help us along the way by creating the IRA, 401K, SEPP IRA, and ROTH IRA savings plans. The problem with these plans is that you are responsible for saving your money.  Investing your money endures market turmoil and eventually figuring out how and when to take your money out so that it lasts your entire lifetime.

For this reason, recent retirees are facing more financial stress than ever. Regardless of how successful you were in accumulating assets during your working years, retirement now is the transition from one career to another - the retirement income specialist. You need a plan to cash out of the retirement and investment accounts that you saved all those years. Your plan (and hence your retirement lifestyle) needs to be flexible enough to adjust as inflation and economic realities change.

The Tools of the Trade

To build your retirement income plan you may want to consider some bonds, because they can potentially generate steady income-cash that you can withdraw and spend. At times, bonds can be as risky as stocks, so you have to educate yourself on the risks. The main thing you must understand is the relationship between the bond’s price, its maturity and the rate of interest it pays. If you are good with numbers or a spreadsheet you can use the set of price/yield functions to run these calculations. As interest rates change in the future it will have a direct effect on the value of the bonds you bought to seek income. Since interest rates are very near zero right now, you need to know what will happen to the value of your bonds when (not if) interest rates rise.

It would be helpful if you could calculate how sensitive your bonds will be to future interest rate changes. This calculation would help you assemble a portfolio of bonds together that would react differently as rates fluctuate and help to reduce the risk that they all decline in value at the same time. By calculating the second derivative of the price/yield function we can solve for the duration of a bond. Duration measures the sensitivity of a bond’s price to changes in interest rates which is just what we will need. For example, if you have a bond with a maturity of 19 years and you calculated its duration at 9, then you know that if interest rates rise 1 percent, the value of the bond will decline about 9 percent. If you find these calculations intimidating, then you might want to cancel that fishing trip to free up more time to spend on your retirement income plan.

Compared to stocks, bonds can potentially provide stability to your income and your assets. Unfortunately, the bond portion of your retirement portfolio will be exposed to inflation risk. Should inflation rise and push the cost of living higher, your bonds will decline in value. As inflation pressures build, investors demand higher rates from fixed rate bond investments to help offset the risk. When the Federal Reserve actually starts to raise rates, the bond math that we discussed earlier becomes applicable. There is only one way for a bond with a fixed annual interest rate (its coupon) to generate a higher rate of return to an investor. They have to be able to buy it at a lower price.  This presents a dilemma for you as you manage your retirement income. Do you cash out of your long term bonds and forgo the higher yields in order to protect the principal value? Do you keep collecting the income from the bonds and hope that inflation doesn’t get out of hand, decreasing the value of your bonds? There is a third option ..

 

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Market Commentary - September 2010

Equities ease lower, bonds up again

In August, markets gave back more than half of their July gains, and most equity markets saw negative returns for the month. The S&P 500 Index lost 4.51 percent for August, and the Dow Jones Industrial Average lost 3.91 percent; the indices are negative for the year by 4.62 percent and 2.11 percent, respectively. It has been the worst August since 2001 and the only losing August in the past five years. The markets threw investors a curveball, and we did not see the summertime market rally that many analysts had predicted. Now markets need to regain momentum in what has been a slowing economic recovery over the past several months.

Interest rates continued to plummet across all maturities in the U.S., as investors showed a healthy appetite for U.S. Treasury debt. Yields on the 10-year Treasury fell from 2.91 percent at the end of July to 2.48 percent at the end of August—the largest monthly decline in yield since the credit crisis began in November 2008. Yields on the 2-year dropped further, ending the month at 0.47 percent, within a couple basis points of the August 24 all-time low in 2-year yields of 0.45 percent. The fall in rates helped bolster bond returns yet again, and the Barclays Capital Aggregate Bond Index rose 1.29 percent, leaving it 7.83 percent higher for the year.

Municipal bonds had a very strong month, with the Barclays Capital 10-Year Municipal Bond Index returning 2.77 percent and now up 8.76 percent for the year. Longer-maturity municipal bonds have been helped both by the move lower in interest rates and improvements in bond prices relative to Treasuries. Although many municipalities are feeling the strain of the economy, it seems that investors are looking past these issues and are less fearful of longer-maturity paper in general.

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Anatomy of a Bubble

In recent history, we have been through asset price bubbles in dot-com stocks (1995-2000), real estate (2001-2005) and oil (2003-2008). Each of these situations exhibited similar characteristics. They started innocuously, attracted massive capital inflows, ascended higher than anyone imagined, lasted longer than anyone expected and by the end they mercilessly trapped investors regardless of their acumen. 


Warning signs are gathering that the U.S. bond market may be the next bubble to burst. Even while stock investments are experiencing net redemptions, investment companies are collecting record inflows into Bonds. In the face of strong demand, Treasury yields are at historic lows which correspond to historically high bond prices.

A recent Bloomberg article calculated that more money is flowing into bonds right now than flowed into dot-com stocks in 2000. These sudden, massive cash inflows complicate the long-term fundamentals of these markets.

Much of the bond market’s current appeal lies not in the high yields, but in the relative lack of desire for the alternatives. Stocks are trading sideways as forecasters are debating whether our economy will continue to improve or descend back into recession. In the face of such economic uncertainty, stock investors are leery of taking too much risk with the few shekels they have left after the recession. At 1.5 percent or less, conservative investors who normally keep their money in the bank are not making enough to stay put. Real estate investors still are trying to sell property and de-leverage, so they can stave off bankruptcy. It is impossible to escape the non-stop barrage of advertisements to buy gold. Fortunately, investors are leery of buying into a commodity that does not pay any interest, especially after it has nearly tripled in the past five years. In this environment, bonds are winning by default. They seem like the least bad choice for investors to get paid. For bond investors, current headlines could not be any better.  

 
So, is this truly a bubble that will leave investors with regret or just the “new normal” that some commentators are saying we should expect? Is inflation gone? Are bond yields going to stay low as our government grows to become half or more of our economy like some of our European counterparts? Will bond investors have time to clip a few more coupons before heading to the exits? I do not know the answer to these questions, and to be honest no one else does either. I do know what will happen if bond investors get the answers wrong. Bubbles can be characterized by an almost hypnotic trance that even sensible investors can fall into the trap. They always think they will have time to get out, but they seldom do.


For our part as investment professionals, we are being prudent. We have reduced our client’s exposure to long-term, fixed-rate bonds. We didn’t overstay our welcome. We probably left the party early. It might get really exciting in the wee hours to come, but we will not have a hangover when the sun (and inflation) rises. It is easy to spout axioms like “sell when the news is good; buy when the news is bad.” Through humility, successful investors put these words into action.    

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Municipal Bond Investing

Municipal bonds offer conservative investors an attractive mix of characteristics. We have decades of experience in trading individual Tennessee municipal bonds for our discretionary and brokerage clients. We have the experience to effectively address the inherent risks of municipal bonds and to navigate the myriad of primary and secondary offerings in the market. We exercise due diligence in analyzing the unique terms of each prospective bond before we invest or recommend it:

  • Credit risk
  • Call Risk
  • Yield analysis
  • Duration
  • Reinvestment risk
  • Issue specific concerns- extraordinary calls, bond covenant terms, debt coverage ratios

Our decision making process isn't complete until we effectively negotiate a competitive price execute the trade at the best price that we can. This is a labor intensive process that LeConte adheres to even as our competitors through lack of expertise or attention to detail, fail to execute. When circumstances dictate a bond sale, we exercise the same diligence on that side of the transaction as well. Individual investors may find it difficult to sell individual State and local municipal bonds at good prices or in a timely fashion. During our tenure in the industry, we have developed an extensive network of contacts that help us find buyers and bid competitively.

Disclosure: Municipal bonds are federally tax-free but may be subject to state and local taxes, and interest income may be subject to federal alternative minimum tax (AMT). The purchase of bonds is subject to availability and market conditions. There is an inverse relationship between the price of bonds and the yield: when price goes up, yield goes down, and vice versa. Market risk is a consideration if sold or redeemed prior to maturity. Some bonds have call features that may affect income.

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