April 2013 – Monthly Commentary
In April, the stock market continued to climb “a wall of worry,” as investors feared that earnings would disappoint despite better than expected economic activity in the first quarter. Compounding that fear was the 2-day 9.40% slide in the price of gold, which reminded investors that market panics occur from time to time. Despite the worry, both the stock and the bond markets finished the month higher.
Much has been written speculating that the U.S. economy will sputter in the second quarter after showing promising growth in the first, repeating the pattern of the last two years. Driving that worry is evidence that the manufacturing sector softened during the quarter, as witnessed in the purchasing manager surveys and the modest uptick in inventories. We suspect that the softening was precautionary positioning by the sector in advance of the budget sequester, and not necessarily seasonal weakness. Counterbalancing the manufacturing slowdown has been the housing market which continues to demonstrate an improving backdrop. Driven by lean inventories of existing homes and a pickup in new home sales, prices are up 9.3% year-over-year as reported by Case-Shiller. In press releases during the month, KB Home, Toll Brothers, and Pulte all communicated that they intend to limit sales in an effort to manage profitability and squeeze prices higher. As investors, we like to hear comments like that. By managing sales and inventory, the homebuilders will be able to maximize their margins and avoid the mistake of several years ago when buyers canceled pending sales en masse. Also contradicting the slowdown fear is the employment situation. The release of the April employment report showed a revision of the March new jobs report from a meager 88,000 to 138,000, while the April report showed a gain of 165,000 jobs, exceeding the 140,000 expectation. Even more encouraging was the 293,000 jobs added for the month according to the household survey. If job growth continues, we expect that the manufacturing sector will rebound before too long.
The Federal Reserve’s endeavor to depress interest rates by printing money and buying debt in the secondary market continues to be a resounding success. The yield to maturity of Treasury notes across the yield curve continues to trade at the lower end of the post-crisis range. Under the current program of quantitative easing, the Federal Reserve is buying $45 billion in Treasury notes and $40 billion in newly issued mortgage-backed securities each month. At that pace, the Fed is buying approximately 90% of new mortgage issuance and about 70% of new Treasury issuance. In driving down interest rates, the Fed is crowding out traditional fixed income investors and causing them to move into Treasury note substitutes. In the quest for yield, investors are moving into more risky investments including, junk bonds, longer maturity debt, preferred stock, and high dividend paying stocks. In each instance, the investor is assuming a degree of risk that we suspect is not fully understood. Regardless of the heightened risk, each of the above alternatives is clearly benefiting from quantitative easing. The junk bond market, in aggregate, now has a yield-to-maturity of less than 5.00%, the lowest it’s ever been. From a valuation perspective, 5% is not nearly enough yield to offset the risk of default. Similarly, in moving from an investment with a 5-year maturity to one with a 30-year maturity, an investor will boost the annual yield-to-maturity of the investment by 2.24%, however they will boost the magnitude of loss from a 100 basis point rise in interest rates from -4.85% to -19.36%. Less prevalent, but certainly benefiting from QE is the preferred stock market, where structures are typically very long in maturity, but also have an imbedded call, usually five years or less. Typically, preferred securities offer a higher yield than a corporate security of the same maturity, however the risks are greater than a corporate note. Preferred notes are usually subordinate to corporate notes of the same issuer, and because the float of preferred securities tends to be small, they suffer from illiquidity which can be magnified during times of market stress. As for equities, they are a very poor proxy for a fixed income investment. While it’s clear that income hungry investors have become attracted to high dividend paying stocks, the risk of loss of principal is far greater, as is the price volatility. For all the reasons listed above, we continue to position defensively.
While the Fed isn’t buying Treasury Bills as part of its quantitative easing program, it’s indirectly depressing the yield offered in the sector. In some cases the interest rate on Treasury bills has fallen into negative territory. An investor buying a 1-month bill at -0.01% is paying 100.001 in order to get 100.00 back one month later. The driver of the irrational price is the greater than expected tax receipts. Tax receipts in April were 27% higher than that which was collected last April. From that, the Treasury has borrowed a bit less in the bill market and with bank balance sheets flush with the newly printed cash from the Fed, the demand for T-bills is outweighing the somewhat reduced supply, thereby depressing yield to zero.