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The Sandy Spring Way

When central bankers talk, investors listen.

June 18th, 2012 | By Beau Mercer

World stock markets rallied last week on a Reuters report which said major central banks were prepared to take coordinated action if the results of the Greek elections led to market turmoil.

On top of that, later reports said the European Central Bank was hinting at an interest-rate cut and Britain jumped in with a pledge to flood its banks with cash if needed, according to Reuters. This global show of force suggests the world’s political leaders will do whatever they can to keep the financial markets stable.

Interestingly, last week’s economic news in the U.S. and Europe pointed to continued sluggish growth, according to MarketWatch. Normally, you might expect the stock market to drop on weak economic news as it could lead to lower corporate profits. However, investors seemed to interpret the “bad” news as “good” news for the market because the worse things get, the more likely government may step in with more stimulus.

There’s an old Wall Street adage that says, “Don’t fight the Fed.” This means when the Federal Reserve starts firing its bullets to stimulate the economy, it tends to spark a rally in the stock market – even if the economic news continues to look weak, according to MarketWatch. The Federal Reserve, along with other central banks, have already fired $6 trillion worth of bullets in the form of money printing since 2008 and, as a result, many of the world’s financial markets have risen sharply since the early 2009 lows, according to CNBC.

While further stimulus might support the financial markets in the short term, there are two things to consider:

  1. Additional stimulus is subject to the law of diminishing returns. Just like one chocolate chip cookie tastes great, but 10 may make you sick, too much stimulus may eventually backfire.
  2. Additional stimulus improves liquidity, but does not address the solvency issue. Europe and the U.S. still have a solvency problem of too much debt and this debt needs to either be written off or paid off. Solvency is the harder issue to solve. Source: Hussman Funds, June 18, 2012
Data as of 06/15/12 1-Week YTD 1-Year 3-Year 5-Year 10-Year
Standard & Poor’s 500 (Domestic Stocks)

1.3%

6.8%

5.6%

13.3%

-2.6%

2.6%

DJ Global ex US (Foreign Stocks)

2.0

-1.5

-17.4

3.5

-7.4

4.5

10-year Treasury Note (Yield Only)

1.6

N/A

3.0

3.7

5.2

4.9

Gold (per ounce)

3.2

3.4

6.4

20.4

20.0

17.7

DJ-UBS Commodity Index

0.0

-8.5

-20.2

0.7

-6.1

2.8

DJ Equity All REIT TR Index

0.4

10.9

13.1

30.1

0.9

10.1

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.

IS THERE A BUBBLE IN THE BOND MARKET?

As you know, interest rates are near record lows and that hurts savers who were used to receiving relatively high and mostly risk-free income on their savings. For example, back in 2007, 10-year Treasuries yielded about 5 percent, according to the U.S. Department of the Treasury. Last week, the yield was down to about 1.6 percent. Since bond prices move inversely to yield, this means as yields moved to near record lows, bond prices moved to near record highs. And, now, some analysts are asking if bond prices have reached bubble territory, according to Bloomberg.

One of the most recent clear-cut cases of a bubble was the technology boom of the late 1990s. Unfortunately, that was followed by the technology stock bust of the early 2000s. You may recall that bubble was based on greed as investors clamored to get in on the internet frenzy and make some “easy” money.

But, today’s peak in the bond market is just the opposite. It’s based on fear, not greed. Due to economic uncertainty, investors have jumped into bonds to preserve their money and this fear-based demand for bonds has pushed prices up and yields down, according to Bloomberg.

So, can a bubble be based on fear or are bubbles just reserved for greed-driven extremes? In reality, we’re not as concerned about the definition of the bubble as we are about the possible unwinding of the bubble.

The technology bubble of the late 1990s and the strong bond market of today are great examples of two things that can drive markets to extremes – greed and fear. In the end, whether driven by greed or fear, extreme movements in the financial market tend to eventually reverse themselves and revert back to the mean. Our job as your financial advisor is to acknowledge these emotions, but not get caught up in them. We do our best to remain rationale and analytical in the face of greed and fear so we can do the best job possible in securing your financial future.

Weekly Focus –Think About It…

“Individuals who cannot master their emotions are ill-suited to profit from the investment process.”

–Benjamin Graham, investment manager, author, Warren Buffett mentor