Stocks finally broke out of their trading range after the Memorial Day holiday as investors decided that the economy was in fact growing (and that the -1.0% GDP figure for the first quarter of 2014 was a largely weather-driven anomaly). Bond yields had fallen as far as 2.41% (10 year Treasury) on May 29th, but recent economic reports have indicated that demand is recovering. Last Friday’s employment report seemed to confirm the emerging consensus that the first quarter’s deflationary omens could and would be overcome. It boils down to faith in the world’s central banks, which remains strong. The European Central Bank is willing to push interest rates so low that depositors earn a negative savings rate. The U.S. Federal Reserve continues to signal that there is no unemployment rate at or under which they will be compelled to raise rates. Both Japan and China have signaled market-friendly policies in recent days. It becomes difficult to be short term stock bearish when world central banks are telling investors everything they want to hear.
Breadth has improved as well. I was very concerned three weeks ago that market leadership was narrowing away from small caps and cyclically sensitive stocks, and I said that trend bore watching. Once again, rather than the blue chips following the other stocks down, what we saw was a bounce by the lagging sectors. The Russell 2000 is still behind the S&P 500 by close to 5.5%, but this spread was over 7% four weeks ago. The key fact is that the upward trend has resumed.
There are basically three possible scenarios – rapid economic acceleration, anemic economic acceleration, and economic deceleration. The first would soon lead to fears of inflation since the money supply has been expanded so greatly over the past few years. Bonds (incuding lower rated bonds) would perform terribly from the get-go, and stocks would follow soon after. Hard assets like gold would probably perform best. Economic deceleration, on the other hand, would be bullish for high quality bonds and bearish for almost everything else. A continuation of our anemic economic performance, while it would be politically and socially problematic, is still the best case for investors (both bond and stock). Remember – artificially low interest rates = artificially high stock and bond prices. Anything that would change this environment is market negative.
Emerging markets have done quite well over the past three weeks. Sometimes when a sector is out of favor and cheap you have to hold your nose and buy. We are all aware of the problems in China and Brazil but the the emerging world is a lot more diverse than that. Latin America and India have provided the spark. To me, this is a more attractive play than Europe because the former has performed very well over the last 12 months and the recent election results suggest many Europeans believe the current policies are not working.
There are a few funds whose year to date performance is worth highlighting; in the Large Cap Growth area American Funds (AMCAP) and Parnassus Endeavor (PARWX); in the Large Cap Blend area Oakmark Select (OAKLX) and Putnam Multi-Cap Core (PMYAX). Other funds of note are: Vanguard U.S Value (VUVLX), T. Rowe Price Value (TRVLX) and Dodge & Cox International Stock (DODFX).
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