2013: Are You Betting On The Fed, Or The Economy?

 |  Includes: KTF, MUE, NUV
by: John Gerard Lewis

A decade of market savants came out in the December 17, issue of Barron's with an unrepentantly bullish outlook for stocks in 2013. Their average predicted gain was 10%, with increases ranging from Adam Parker's uninspiring 1.4% to Stephen Auth's euphoric 17.4%. Achievement of the latter would put the S&P 500 index within a stone's throw of its all-time high.

Rarely do we see financial houses - which have stuff to sell to investors - trotting out pessimistic messages during Advent, so the forecasts of Parker (of Morgan Stanley), Auth (of Federated Investors) and the other eight aren't surprising. They variously cite improving circumstances surrounding the European sovereign debt situation, economic growth in emerging markets, and a likely retreat from the fiscal cliff.

And the Barron's writer assure us, albeit in little more than a footnote, that, oh yes, these folks do remain well aware of the potential risks, which simply consist of their possibly being wrong about all of the aforementioned reasons that they otherwise adduce for being optimistic.

But I think they missed one risk. And it's a potential doozy.

In fact, it's at the top of the list for three even more heralded stalwarts who are just as unrepentant in their warnings about the financial markets. Indeed, Pimco's Bill Gross and Mohammed El-Erian coined the "New Normal" tag a couple of years ago to describe the economic and investment effects of global deleveraging that has been under way for a while.

Slow economic growth, they contend, will continue for perhaps many years. The days of 10% average annual stock market returns are over, they say. Instead, investors should expect "bite-sized," single-digit returns - for a long, long time.

Also comes star bond fund manager Jeffrey Gundlach, who shares in the gloom. He avers that a "financial catastrophe" is en route, and investors should thus focus on capital preservation and inflationary times.

And economist A. Gary Shilling is no less dour, declaring that a market plunge is inevitable. The rise in equities over the past year, he says, has been due to a contrived factor: the Fed's easy-money response to an ailing economy. Investors have come to pin their hopes on the Fed's actions (the "Bernanke Put"), he says, instead of the reasons for those actions.

"I disagree with the 'It's so bad, it's good' crowd," Shilling says. "Conditions are so bad, they are just plain bad." He says it will take up to seven years for Fed stimulus to have any effect on the economy, and thereby the markets, because it will take that long for global deleveraging to run its course.

"This grand disconnect is profoundly unhealthy - and a reconnection is inevitable," Shilling says. "When that happens markets will nose-dive."

Can the markets continue to rely on bad news being good news for seven years? Can such reliance last even into 2013? Who knows? But do you want to take that chance?

If not, here's a recommended investment allocation as we head into 2013:


Individual corporate bonds. Bond funds expose you to "maturity uncertainty," i.e., you simply don't know what the value of your principal will be at any given point in the future. Therefore, build a ladder of individual, investment-grade corporate bonds for the bulk of the portfolio. An inviolable rule: Hold them to maturity. This allows you to reinvest in higher yields as bonds mature over time - without having to worry about price fluctuations. Don't try to trade bonds when interest rates are low, as the principal value will become less than your purchase price when rates start rising.

If you really don't want to own individual bonds, you can invest in two low-cost bond funds: Vanguard Short-Term Investment-Grade Bond Fund (MUTF:VFSTX), and Vanguard Intermediate-Term Investment Grade Bond Fund (MUTF:VFICX). The fund managers can do the reinvesting for you. But stay away from long-term bond funds that will get killed when rates rise.


With the rest of your fixed-income portfolio, reach for some yield. But even here, be careful, because a pure high-yield bond fund has two serious risks: 1) the potential for net asset declines when interest rates rise, and 2) defaults due to a bad economy. A 5% allocation to pure junk might be OK, but for the rest I would invest in one or more of the following:

• The Covestor Stable High Yield model that we manage at Covestor.com. This portfolio is akin to an aggressive bond fund that's balanced by short-term bonds and cash to mitigate extreme losses or gains. It's a barbell approach that doesn't bet on a decline in bond prices, but has built-in brakes that kick in to at least slow any decline that might be caused by higher interest rates.

• High-quality, closed-end bond funds that use leverage to yield 4%-5%. And if they're municipal bond funds, they will be tax-free and therefore have real return of 6%-7%. Many are offered by BlackRock, Eaton Vance, Nuveen and Pimco. Examples: BlackRock MuniHoldings Quality Fund II (NYSE:MUE); Nuveen Municipal Value (NYSE:NUV); and DWS Municipal Income Trust (NYSE:KTF).

• The DoubleLine Total Return Bond Fund (MUTF:DLTNX) is another barbell fund. It currently yields 6% and has an average duration of just 1.6 years. That means that if interest rates were to rise 1%, the net asset value of the fund would theoretically fall just 1.6%. That's pretty low. And, of course, you'd still theoretically be getting 4.4% on your money.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long VFSTX, VFICX, DLTNX, and the Covestor Stable High Yield model, which I manage.