July 14, 2011
The second quarter of 2011 provided a rollercoaster ride in the stock market that will look uneventful in the history books. April was a strong month for the market, but by mid-June the S&P 500 had fallen more than 7% from its April high, erasing the first quarter gains and falling back to where it was in December of 2010. In the last two weeks it jumped nearly 5%, recouping the first quarter gains and providing a 6.0% return for the year to date, when dividends are included.
Other markets experienced a similar pattern, as the relevant news was global in nature. Oil prices are up; inflation is threatening the developing economies in China, India, and Brazil; sovereign debt in Greece and some of the other EU countries is a problem; and the US economic recovery remains sluggish. None of these issues are going away, and any hint of growing uncertainty sends markets downward, but any hint of improvement sends markets in a positive direction.
Bonds contributed significantly to portfolio returns in the second quarter, so more conservative portfolios benefited from holding larger bond allocations. This return, once again, came from a decline in rates that drove bond prices higher. The quarterly return of 2.3% for the broad bond market index (Barclays Capital US Government/Credit Index) was nearly equal to its annual yield (interest return). It is worth keeping in mind that the opposite will happen at some point – when rates rise a similar amount, bond prices will fall, and the loss in value will wipe out an entire year’s worth of interest income.
“The Sky is Falling!”… Can we please ignore the noise? “Economic worries drove a plunge in US stocks Friday morning, pointing to a sixth straight weekly decline that would be blue-chip stocks’ longest skid since 2002” – (Dow Jones June 10, 2011)
That headline seems almost silly in the context of a quarter that delivered flat returns on blue-chip stocks, but it apparently sells newspapers, and we read something similar every day the market went down last quarter. Markets are volatile. Enduring volatility is necessary if investors hope to enjoy the long-term rewards expected from stock market investment. So…ignore the noise.
Lessons we should learn from Bernie Madoff
A new book came out recently entitled The Wizard of Lies, and the author, Diana Henriques, was interviewed by Morningstar. She makes several interesting observations including the fact that Madoff did not try to exploit people’s greed, as do most Ponzi schemes, promising outsized returns. He instead seduced them with consistent returns that exploited their fear of losing money, providing yet another reminder that risk and return cannot be separated in the real world.
She also compares Madoff’s operation to the relative safety of a mutual fund when she asks, “…what was he running? He was running a secret, unregistered, unregulated, sort of quasi-hedge fund that produced no prospectuses,” whereas mutual funds have auditors, and third-party custodians that can verify the existence of fund assets.
This observation brings some old, but simple truths to mind:
1) If it sounds too good to be true, it probably is;
2) If no one can really explain why it works, you should not buy it; and
3) It is good to trust, but verify.
Since the Madoff scandal broke, many investors have been worried about the safety of their investments. The role of a third-party custodian is critical. Rockbridge relies on third-party custodians, like Charles Schwab and TD Ameritrade, to provide monthly statements to our clients that verify every asset and transaction in their accounts. The Madoff fraud relied on clients accepting verification from a Madoff owned and controlled custodian. Independent verification makes the scheme impossible to replicate. Investment risk cannot be avoided, but the use of an independent custodian is a simple safeguard that should give investors confidence that their assets are safe from fraud.