Quarterly Perspective for 2Q14

Summary

 

The stock market rally continued through the second quarter of 2014.  There was a brief -4% “correction” in early April but stocks quickly recovered and continued to make modest new highs throughout the rest of the quarter.  The market has risen steadily without as much as a 10% pullback since June 2012.  Obviously, this can’t last forever.  That said, there are few signs that it is about to end.

 

Figure 1: S&P 500

Source: Stockcharts.com

 

Overall, the U.S. stock market gained 4.9%[1] in the second quarter (see Figure 1).  Large company stocks performed quite a bit better than small caps, with the S&P 500 rising 5.2% and the Russell 2000 ahead only 2.1%.  The April correction was much harder on smaller stocks, though they had a very nice recovery in June.  Energy stocks soared 12.1% last quarter to lead the way, while financial stocks gained just 2.3%[2].  Stock market performance this year cannot be explained neatly by risk appetite, growth potential, or interest rate sensitivity.  Sector specific factors have been the most significant component of returns; for example merger activity has positively impacted the health care sector, while consumer weakness has hurt retailing stocks.

 

Foreign stocks gained 4.6%last quarter while emerging markets bounced back 6.6% from their first quarter decline[3].  Latin America and Asia performed well for a change, while Europe’s 3.3% gain brought up the rear.  Investors seem to have shrugged off earlier concerns about the Ukraine, China, and Iraq, but of course one never knows when they will resurface.

 

In the bond market, the positive investment climate from the first quarter largely carried over.   The Barclays Aggregate Bond Index gained 2.0%, and riskier classes of bonds (emerging market debt and high yield corporate and municipal bonds) performed even better.  Short term bonds rose just 0.3%[4].  Bonds investors have been paid well over the last five years by taking extra risk.  I am increasingly concerned that investors are looking at non-government bonds as a kind of “free lunch” since their yields are higher.  That would be a mistake.

 

Activity

 

When things are going well our primary job is to look for funds that are underperforming their benchmark and then to determine whether or not that underperformance is likely to be temporary, and thus recoverable.  If not, we replace it with a fund with similar objectives whose managers are navigating the current market environment more skillfully.  We made a couple of exchanges in the international and small company stock areas for this reason.  We also trimmed the Sequoia Fund.  In general, we sought to increase average market capitalization (move from small to large) and from growth-oriented to value-oriented.  Both of these moves made our portfolios a little more conservative.

 

Outlook

 

At this point, there are two concerns I believe could end the current bull market in the next few months.  One is a return of the European sovereign debt crisis and the other is a negative market response to Federal Reserve policy.  To be clear, at any given time there are many other things that may negatively affect the market but I believe those two to be the most pressing.

 

I worry about the European situation because those governments believe the implicit guarantee by the European Central Bank (ECB) to back their debt against default makes it ‘safe’. This strikes me as not too different from believing U.S. mortgage debt was ultra-safe a decade ago because all of the rating agencies said it was.  At some point, the ECB’s policy will be a significant problem.  However, predicting just when that will occur is extremely difficult.

 

With regards to the Federal Reserve, the Board of Governors is doing intellectual contortions to justify the continued low interest rate policy.  The national Unemployment Rate is now within their stated target range and inflation measures have begun to moderately rise (another policy goal).  Thus far, the Fed’s remarkable credibility has been a major determinant in the success of Quantitative Easing (QE).  Credibility, however, is a fragile thing and just because QE hasn’t caused a spike in interest rates doesn’t mean it won’t do so in the future.  If they lose it and bond investors demand higher rates to protect them from inflation, bond and stock prices will both tumble.

 

All of that said, however, we remain in a ‘best-of-all-worlds’ environment in which the economy is growing but not too strongly.  With such a favorable backdrop both stock and bond investors may continue to make money well beyond the rest of this quarter.   Our luck could hold.

 

Commentary

 

Those of you that have read past commentaries know that I am interested in the concept of odds.  Two quarters ago I wrote about stock valuations (Come On Stocky!) with the idea being that cheap markets put the odds of good returns in your favor and expensive markets stack the odds against you.  I qualified this message by stating that valuation does not move markets in the short term (expensive markets can, and usually do, get even more so before they top out), but it is always important in the long term.  If it were known, however, that the Federal Reserve was actively trying to manage investor expectations so as to engineer favorable market performance (believing that strong markets will improve the employment situation) then how much attention should one give to stock valuations?  Regardless of how cheap or expensive the market might be, in the absence of some major external shock, stocks are going to go up until the Fed changes this policy.

 

As money managers, we do a lot of research on past market cycles with the belief that such information will be useful in predicting future market cycles.  We want to know if there are factors that signal that the market is cresting or about to peak, because that would theoretically be an excellent time to reduce risk.  In the past, rising measures of economic performance (capacity utilization, industrial production, raw material prices paid, etc.) were signs that the Federal Reserve would have to begin raising interest rates to prevent a surge in inflation.  So too was a flattening yield curve.  Today, however, the Federal Reserve seems to want to create an investment climate that is perpetually favorable with its very low interest rate policy and refusal to incorporate any data suggesting the business cycle is actually fairly advanced (rising food and energy prices).  Additionally by manipulating the bond market through the purchase of treasuries and mortgages (QE), the Fed achieves an upward-sloping yield curve that suggests a mid-business cycle environment, which is favorable for investors.

 

You might be thinking; “wouldn’t it be perfect if the Fed could maintain a favorable investment climate forever?” Perpetual growth, no recession, no sustained stock market declines – what’s not to like?  The problem is that favorable business and market conditions create economic excesses.  Unlimited liquidity (as much cheap credit as a business needs) means poorly run companies don’t go out of business, they just limp along and negatively impact the profitability of their competitors.  It means there is no competition for limited credit, so savers earn extremely low rates of interest.  It means that leverage is cheap, so the best investment returns go to the most financially reckless.

 

So manipulating the credit markets is undesirable because it fosters bad financial behavior.  Is that the only drawback?  Actually, no.  The other is that it ultimately fails.  Economic and market cycles can be altered but not eliminated.  Ultimately the dam bursts.  The Fed will ultimately be forced to begin restricting credit, and markets will then lurch from risk-on to risk-off.  Valuation will suddenly matter again.  When the pain of bad economic decisions finally arrives it’s much more acute because many people didn’t understand the gravity of their past economic behavior. They “just did what everybody else was doing” (think of all those who re-financed into adjustable rate mortgages last decade).

 

One last idea; I noted on the first page of this commentary that stocks have not had a -10% correction in over two years, which is quite unusual.  That may not be a good thing.  Small losses enforce the idea of prudence, and prudence helps us avoid large losses.

 

We are doing our best to navigate this environment.  We really don’t see a great deal of near term economic risk, but in an artificially low interest rate environment that may not be the critical factor.  We know valuation is not an effective timing tool; rather it is more like a guidepost on a very complicated trail.  At the bottom of the market in March 2009 prices were so cheap that success was almost assured if one had a time horizon of more than, say, six months.  It was the financial equivalent of needing to roll anything except a “1” on a six-sided die.  Today valuations are in the upper 10% of their historical range, which suggests we need to roll a five or a six.  Despite the seemingly bad odds, the stock market keeps rising because everybody knows that world central banks have supplied the markets with the equivalent of loaded dice.  But as I have stated, they can’t do this forever.

 

To be clear, I don’t dislike the Fed.  In fact I believe their actions in 2008 kept things from becoming a whole lot worse.  My concern is simply that by expanding their balance sheet (QE) and keeping interest rates artificially low they may have created a situation where they can’t back away from these policies without creating a lot of turmoil in the markets.  Stocks have had a great run since 2009 and are clearly on the expensive end of their historical range.  Although the internal market measures we monitor look good right now, this ‘best of all worlds’ environment may present a situation in which we don’t want to wait until the last note played.  The race to the exits, when it comes, might be especially rough this time.

 

Remember, we update our blog periodically with my latest thoughts on the market.  (www.trademarkfinancial.us/blog)  If you’d like to be added to the blog update distribution email list or to begin receiving your statement electronically please contact Cynthia Gates at cynthia@trademarkfinancial.us or 952-358-3395.

 

We appreciate your continued trust in our management program,

 

 

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