In many ways, the second quarter of 2014 was a continuation of the past several quarters. After a weather-induced first quarter dip in GDP, the U.S. economy resumed its modest recovery from the “Great Recession” of 2007-09. The Federal Reserve “tapered” its quantitative easing (QE) program but still purchased $310 billion of bonds during the first half of the year. U.S. stocks continued to drift up—the conventional wisdom being that while valuations were not compelling, as long as the Fed was providing “liquidity” and near-zero interest rates, it was safe to continue buying. In fact, failure to keep buying exposed investors to the risk of being left out of the continuing bull market.
We have been wary for some time about the level of stock prices relative to underlying business values. We own some excellent companies and they continue to grow in value, but in many cases, their stock prices have risen even faster. Price sensitivity and investment discipline dictate that we sell the expensive and if reasonably priced replacements are not available that we hold cash. So, our cash reserve levels remain elevated in the mid- to upper-20% range. This cash “anchor” held back second quarter and first half returns, but we think the “opportunity cost” of holding out for better values is slight and that we will be rewarded for our patience.
While QE has had an indirect effect on stocks, bond prices have been impacted directly and significantly. The resulting bond market rally has produced positive total returns (interest income plus capital appreciation) for longer-term bonds, but has left prices artificially inflated and yields suppressed. The Fed can maintain this (surreal?) situation for a long time (it already has), but eventually bond buyers will insist on being paid more (higher yields) on their investments. Our Short-Intermediate Income Fund holds a relatively short, high quality portfolio. We think it will provide reasonable protection for bond investors when reality returns to the bond market.
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