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The Sandy Spring Way

Add another country to the European bailout list.

June 11th, 2012 | By Beau Mercer

Over the weekend, Spain requested up to $125 billion in bailout money to shore up its ailing banks, according to Bloomberg. Spain’s banks and the country’s economy are reeling from the bursting of a massive property bubble. Things are so bad in Spain that the country is back in recession and nearly 25 percent of the country’s workers are unemployed, according to The Wall Street Journal.

Spain matters because it’s the fourth largest economy in the euro zone and if it goes bust, it may create chaos in euro land.

Fortunately, if all goes according to plan, the new bailout money may be enough to reassure investors that Spain won’t go the way of Greece. Speaking of Greece, the next big event in the ongoing euro zone debt crisis takes place this coming Sunday when Greece holds a new election. Depending on who wins, it could lead to “Grexit”—which means Greece leaving the euro. There is no precedent for a country leaving the euro so if it happens with Greece, we’re in uncharted territory.

Back in the states, Fed Chairman Ben Bernanke spoke last week and said, “The situation in Europe poses significant risks to the U.S. financial system and economy and must be monitored closely.” He went on to say, “The Federal Reserve remains prepared to take action as needed to protect the U.S. financial system and economy in the event that financial stresses escalate.” While he didn’t announce another round of quantitative easing, the markets were somewhat reassured that he might pull the trigger if the economy gets much worse.

And let’s not forget China. They just announced a surprise interest rate cut which “raised concerns over the state of the economy,” according to MarketWatch.

So here we are again, monitoring the situation in Europe, worrying about a hard landing in China, and analyzing whether the Federal Reserve will ride to the rescue and print more dollars. It keeps our job very interesting!

Data as of 06/8/12 1-Week YTD 1-Year 3-Year 5-Year 10-Year
Standard & Poor’s 500 (Domestic Stocks)

3.7%

5.4%

4.3%

12.2%

-2.5%

2.6%

DJ Global ex US (Foreign Stocks)

2.0

-3.4

-20.2

2.9

-7.3

4.0

10-year Treasury Note (Yield Only)

1.6

N/A

3.0

3.9

5.1

5.0

Gold (per ounce)

-1.8

0.1

2.5

18.7

19.2

17.2

DJ-UBS Commodity Index

1.6

-8.5

-22.5

0.8

-5.4

3.0

DJ Equity All REIT TR Index

4.5

10.4

8.9

26.9

0.6

10.2

Notes: S&P 500, DJ Global ex US, Gold, DJ-UBS Commodity Index returns exclude reinvested dividends (gold does not pay a dividend) and the three-, five-, and 10-year returns are annualized; the DJ Equity All REIT TR Index does include reinvested dividends and the three-, five-, and 10-year returns are annualized; and the 10-year Treasury Note is simply the yield at the close of the day on each of the historical time periods

Sources: Yahoo! Finance, Barron’s, djindexes.com, London Bullion Market Association
Past performance is no guarantee of future results. Indices are unmanaged and cannot be invested into directly. N/A means not applicable.

SOMETHING HAPPENED ON NOVEMBER 18, 2008 THAT HADN’T HAPPENED IN 50 YEARS

What was it and what are the implications for your portfolio?

Before we get to the answer, we need a brief review of history. Up until 1958, the dividend yield on common stocks was higher than the yield on bonds. This seemed to make sense because stocks were generally riskier than bonds and in order to entice investors to buy stocks, they had to be incented with a higher yield. But in 1958, that flipped. Stock prices rose, the dividend yield fell and the yield on bonds became higher than stocks. For the next 50 years, this relationship remained as bonds continued to out-yield stocks.

Then, on November 18, 2008, the relationship reversed as stocks delivered a higher dividend yield than bonds. This was just a brief flirtation and the relationship flipped again shortly thereafter and bonds resumed their usual higher-yielding status.

Now, with the dramatic decline in bond yields, stocks are doing that rare thing and delivering a higher yield than bonds, according to the Financial Times.

Here are several thoughts on the implications of stocks yielding more than bonds.

  1. Investors are more risk averse. With bond yields extremely low, this suggests investors are more concerned about safety than double-digit returns.
  2. Bond prices are at an extreme level. With 10-year Treasury yields having recently touched an all-time record low, there may not be much room for them to go lower—since 0 percent is the floor.
  3. Government intervention may be distorting the normal relationship between bonds and stocks. Heavy bond buying by the Federal Reserve could be artificially depressing bond yields and rendering some of the traditional market relationships moot.
  4. Investor psychology may change over time. Prior to 1958, investors wanted a higher yield from stocks because stocks were riskier. Then, over the next 50 years, bonds had a higher yield as investors became comfortable with the idea that stocks offered a yield plus a chance for capital appreciation—even with more volatility. And now, we’re back to risk averse investors seeking higher yields from stocks.

Sources: Financial Times, BusinessWeek

From an investment standpoint, seeing a major change in a long-term trend like the yield relationship between bonds and stocks suggests we may be at an extreme level in bonds and stocks. And while nobody knows how long it may take for this relationship to return to a more traditional level, we’ll try to find ways to profit from it on your behalf.

Weekly Focus –Think About It…

“And so with the sunshine and the great bursts of leaves growing on the trees, just as things grow in fast movies, I had that familiar conviction that life was beginning over again with the summer.”

–F. Scott Fitzgerald, author