A Silver Lining For Bonds If Interest Rates Rise, From Stephen J. Huxley, chief investment strategist at Asset Dedication
Over the past few years, declining interest rates have caused the market value of fixed income holdings to increase. Rising rates, as many advisors are anticipating this year, will have the opposite effect, causing the market value of money invested in bonds to fall. If interest rates rise in rapid fashion, the drop in value will give financial journalists a field day describing what they will call the bursting of yet another bubble—the bond bubble. (This raises another question: does every decline mean there must have been a “bubble?”).
But rising interest rates have a silver lining. For retirees who use a dedicated portfolio that ladders bonds and hold them to maturity in quantities that match their cash withdrawals, higher interest rates are a welcome sight. Rising interest rates mean that someone setting up their cash flow matching ladder for the first time will pay less to get that secure income stream (coupon plus interest).  
For example, if a bond ladder to provide a protected 8-year stream of $50,000 a year plus 3% inflation each year costs $400,000 right now, higher interest rates next summer may drive the cost down to $360,000. Unfortunately for those who rely on bond funds for their fixed income allocation, the value of their fixed income investments will likely decline—unless they happen to be lucky enough to buy one of the few bonds funds that wins its gamble on future interest rates.

Time to Hedge, From Christopher Sheldon, director of investment strategy at Bank of New York Mellon

Despite relative performance lags in 2009, we continue to believe that, in 2010, maintaining or even adding hedge fund exposure will be appropriate for most clients. We expect broad equity advances are likely to be more muted than those experienced in much of 2009. Also, we expect volatility, which fell considerably as last year progressed, to increase in 2010. The first part of the year may be more volatile as investors reposition portfolios after 2009’s large gains. Ongoing tensions about the shape and vigor of economic recovery likely will continue. Questions about the appropriateness of the Fed’s interest rate policy and the timing of its exit strategies away from financial assistance may also add uncertainty. Throw in concerns about the dollar, inflation, the deficit, rising taxes and high unemployment, just to name a few, and it is not hard to see how volatility could increase. Periods of moderate return with higher-than-average volatility often are when hedge fund managers shine.

We think it would be a mistake for investors to forgo hedged equity exposure in favor of long-only equities, even if market events do not unfold as we expect. Our expectation for more modest market gains is based on greatly improved profit growth in 2010 for many companies. Some of this already has been discounted into current prices. As the year progresses, we also believe that investors increasingly will become convinced that the U.S. economy is transitioning to an expansionary phase, not just recovering. This most definitely is not priced into markets and whether we truly are moving in that direction can certainly be vigorously debated. If our expectations for continued, though more modest, growth do not pan out, or if some of the concerns noted above move to the forefront, it is possible that investors will place increased value on the downside protection of hedged equity strategies.

It Didn’t Have to Be This Ugly, From Rob Arnott, chairman of Research Affiliates

Plenty of asset classes existed at the end of the spectacular 1990s that, unlike equities, offered attractive risk premiums. Almost all were cast aside as stocks rose to the stratosphere on the tech bubble. Ignoring diversification, investors plowed their money into the U.S. stock market to such an extent that the P/E ratio (using Robert Shiller’s 10-year reported earnings) of the S&P 500 stood at a shocking 44 in December 1999. Because these other asset classes were ignored, they entered the decade with much more reasonable valuations and, accordingly, produced respectable results over the subsequent 10 years. Only U.S. large stocks managed negative returns for this period.

Widening our opportunity set, the decade doesn’t appear so bleak. True, the S&P 500 and the EAFE, along with the ubiquitous 60/40 blend, posted negative real returns. However, decent results could be had as three asset classes produced double-digit returns— emerging market stocks, emerging market bonds and REITs. Another four asset classes—emerging local currency, TIPS, long Treasuries and (surprise, surprise!) fundamentally-weighted global stocks—managed to beat inflation by 5% or more. Equally weighting this collection of 16 asset classes (excluding T-bills and the fundamental indexes, which didn’t exist 10 years ago) produces an annualized return of 6.8%—a 4.2 percentage point premium to inflation. A 6.8% return may have missed many institutions’ return targets, but it could hardly be considered a disastrous shortfall. By embracing a wide assortment of asset classes (in this case, 10 bond-like categories, 4 equity applications, REITs, and commodities), this approach offers diversification and, more importantly, the opportunity to invest in cheap assets and avoid overly concentrating in the most expensive.

Positive Indices Should Energize Bull Market, From David Kelly, chief market strategist for JPMorgan Funds

New and Existing Home Sales are both likely to be weak in December, mirroring weakness in the November Pending Home Sales Index and December Housing Starts. However, the housing market still seems set to improve in 2010. Consumer confidence and sentiment readings should look soft, largely reflecting increased political partisanship. On the positive side, the Durable Goods report, due out on Thursday, should show a very solid gain reflecting a major step up in Boeing orders at the end of the year. Most important, and potentially impressive will be the GDP report on Friday, which could show as much as a 6.0% annualized gain in output in the fourth quarter, reflecting an abrupt end to the heavy inventory cuts of the spring and summer of 2009.
One remarkable aspect of this GDP gain, should it transpire, is that it will have been achieved with a decline in total hours worked and only very modest gains in compensation, which should be reflected in Friday’s Employment Cost Index report. The strong productivity and margin gains suggested by these reports also hold the key to the earnings season, which will be in full swing this week with 136 S&P500 companies reporting. So far, this earnings season, about 76% of companies have beaten expectations with S&P500 operating earnings tracking a number of $16.69, up healthily from $15.78 in the third quarter. Non-financial companies, in particular, have been beating estimates by handsome margins, and with reports from the biggest financial names out of the way, the earnings news this week should be very positive.
President Obama will deliver his State of the Union Address on Wednesday. While he must be very disappointed to have lost the Senate seat necessary to push through his health care plan, logic would suggest offering an olive branch across the aisle, as President Clinton did following the Republican takeover of Congress in 1994. This may be a precursor to a slightly less activist government between now and the next presidential election.
Meanwhile, the Federal Open Market Committee meets on Tuesday and Wednesday in its first meeting of the year. They will very likely keep monetary policy in its current very accommodative stance. However, as of today, a considerable cloud of uncertainty hangs over the Fed, due to a stalling out of the reconfirmation process for Fed Chairman Ben Bernanke. While the political history of the last few years suggests that nothing should be taken for granted, presumably some senators will have taken note of the sharp stock market sell off in reaction to fears that Bernanke would not be reconfirmed, and will thus conclude that a further delay in confirmation can serve no useful purpose.
Last week was a tough one for the U.S. stock market with the S&P500 falling by 5.1% from a bull market peak of 1,150.23 reached on Tuesday. While this correction may still have some momentum, the combination of good economics, good earnings, supportive monetary policy and a more balanced political environment should in time allow the bull market to resume.

Report Calendar

Monday, Jan. 25:

December Existing Home Sales

Corporate Earnings: Apple, Heartland Financial USA, Halliburton Co., Peoples Financial Corp., Quest Diagnostics, West Coast Bancorp

Tuesday, Jan. 26:

November S&P/Case-Shiller Home Price Index, January Consumer Confidence Index, November Federal Housing Finance Agency House Price Index, January State Street Investor Confidence Index

Corporate Earnings: Delta Air Lines, Johnson & Johnson, National Instruments, The McGraw Hill Cos., UMB Financial, Verizon, United States Steel Corp., Yahoo

Wednesday, Jan. 27:

December new home sales

Treasury Secretary Tim Geither testifies before House Oversight Committee on AIG

President Barack Obama delivers his first State of the Union address to Congress

Corporate Earnings: AmeriCredit Corp., BlackRock, CGI Group, E-Trade Financial Corp., Piper Jaffray, Qualcomm

Thursday, Jan. 28:

December durable goods orders

Weekly jobless claims

Corporate Earnings: Amazon.com, AT&T, First Commonwealth Financial, Genworth Financial, Janus Capital Group, JetBlue Airways, Proctor & Gamble, T. Rowe Price, US Airways

Friday, Jan. 29:

Fourth quarter 2009 gross domestic product

Fourth quarter 2009 employment cost index

Corporate Earnings: Oppenheimer Holdings, Provident Financial Services