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Did the Markets Overreact?

This week, Accretive Wealth’s CEO Faraz Sattar asked Dan Kern to give us his take on what’s happening in the markets and what he expects in the near future. Dan is president and chief investment officer of Advisor Partners, which provides customized investment portfolios for many of our clients.

Faraz: A few weeks ago, you told us we might see a short-term drop in the market and a rise in Treasury rates, both of which have occurred. Would you discuss the causes?

Dan: We thought the markets were vulnerable to a short-term drop, which is what we saw after the Fed said that it would probably begin to normalize monetary policy as early as September. The Fed news came alongside a troubling spike in interbank rates in China (the rate banks charge each other for overnight funds). Usually the People’s Bank of China steps in to add liquidity when that happens, but they waited this time. We think that was a message telling Chinese banks to become more disciplined and reduce lending excesses.

We think hedge funds also contributed to the downturn in equities, selling off assets they’d leveraged. It was encouraging to see the rebound in equity prices following the initial reaction. It appears that some long-term buyers have come back into the market to take advantage of this downturn.

Faraz: Do you expect the Fed to stick with its previously stated goals of tapering off quantitative easing once unemployment drops to 6.5% and inflation reaches 2.5%?

Dan: The Fed has been buying $85 billion in Treasuries and mortgage-backed securities every month to stimulate the economy. The Fed may begin scaling back bond buys in September, with the expectation that the market will pick up the slack. We don’t expect the Fed to begin raising interest rates until late 2014 or early 2015.

Several Fed members have spoken since the announcement, seemingly to clarify their future intentions. In many ways, we viewed the Fed’s announcement as a positive; it’s encouraging that downside risks to the economy have diminished. However, we think it’s quite possible that the Fed may have to wait beyond September to normalize monetary policy: Growth may be weaker than expected, higher interest rates may slow the housing recovery, and the impact of falling labor participation rates may influence the Fed to change its unemployment target. The 6.5% unemployment rate target may be adjusted downward because so many people have dropped out of the labor market that it isn’t an accurate gauge.

We’ll be watching closely to evaluate economic conditions.

Faraz: Why is the market so jittery?

Dan: Market jitters are understandable—in many respects, we are in uncharted territory. The Fed has bought trillions of dollars of Treasuries and mortgage-backed securities (MBS) to stimulate the economy and is carrying a lot of assets on its balance sheet. The path back to normal monetary policy carries considerable risks. Incremental steps to taper purchases, whether in September or later in the year, seem an appropriate and proportionate policy step. The expectation is that the market will pick up the slack in purchases of Treasuries and MBS.

Faraz: What do you expect from the markets in the near term?

Dan: Our outlook for the markets hasn’t changed dramatically for the long-term, though some of our near-term thinking has changed. We continue to favor US stocks. We think there’s room for growth in corporate earnings and potentially some limited expansion in the price/earnings (P/E) ratio. Market growth over the next twelve months will probably be in the mid to high single digits. We continue to favor cyclical stocks relative to defensive stocks based on relative valuations.

We’re still looking for opportunities to increase our exposure to European equities as things improve. Europe has a long way to go to unwind the problems that have built up over decades. It needs better banking regulation, with more consistent policies for guaranteeing deposits and resolving bank problems. We’re now using passive strategies for large-cap companies and active strategies for small cap.

Our positioning in emerging markets is cautious because near-term fundamentals have weakened. Although emerging markets are considerably less expensive than the US from a P/E perspective (about 11x compared to nearly 16x in the US), many of the flagship markets face significant challenges. We didn’t reduce our emerging markets holdings last week because we thought the selloff was overdone, but we are buying into them gradually for new accounts. Although we have near-term concerns about emerging markets, we do continue to favor emerging markets from a longer-term perspective.

The bond market is interesting, in that upside and downside risks are better balanced right now. The long-term outlook for Treasuries is negative, but 10-year Treasuries at 2.5% may hold some near-term value.

Faraz: Will investors be leaving equities to buy bonds now that the Fed will be slowing bond purchases?

Dan:  We still think that bonds are risky, in that interest rates will drift upward over the next couple of years. The upward trend of rates may pause given the abrupt recent move, making shorter-duration bonds more attractive now than they were two months ago.

Faraz: With the recent run-up, is it still good to go into equities?

Dan: It all depends on your time horizon. If you’re a medium- to long-term investor, then equities are a good choice. If you’re concerned that you might not enter the equity market at the right time, you can enter gradually using dollar-cost averaging. If you’re a short-term investor, then equities are a riskier choice.

If you have any questions, please feel to call Faraz at (925) 365-1533 or send an e-mail to

Accretive Wealth