Market Matters for July 24, 2014

Below is a weekly update from our Chief Investment Officer, Dr. Scott Lummer. He co-hosts an audio segment entitled “Market Matters.” In this week's show, Scott reviews the second quarter of capital market performance and provides his outlook for the rest of the year. His view is that economy seems to be very solid, although there are some potential danger signs. He feels the U.S. stock market is appropriately priced at present, although he has some specific insights for emerging markets and bonds. Each week he covers a different piece of investment news focusing on recent events in the capital markets, and relates them to Savant Investment Group’s perspective on investing.

Episode Transcript

Daphne: Welcome to Market Matters, a weekly discussion about investing in today’s capital markets. I’m Daphne Feng and this week we will review the markets and economy for the first six months with the Chief Investment Officer of Savant Investment Group, Dr. Scott Lummer.

Scott: Hello Daphne, and welcome to the team.

Daphne: Thank you. We just passed the midway point of 2014 – how have markets performed? It’s been a very solid six months. The S&P 500 increased by 7% for the first six months. Small company stocks did not do as well, going up by 3%.

Daphne: What about overseas markets?

Scott: Developed market stocks rose by 5%, and emerging market stocks, after a sluggish 2013, have increased by 6%.

Daphne: So stock markets around the world have fared very well. What about bonds – I know they had a bad 2013.

Scott: Yes there was a lot of volatility in the bond market last year. But this year, the bonds increased in value by 4% for the first six months.

Daphne: Thus far it’s been a good year to be an investor. Is that because the economy has been doing well?

Scott: In general, yes. Most of the economic indicators have been favorable. Gross domestic product, both in the U.S. and worldwide has been increasing, and is expected to continue to grow at a slow but steady rate. The unemployment rate continues to decline – it’s currently at 6.1%. Inflation remains low. And most importantly, corporate profitability has been growing, and is expected to continue to increase in the future.

Daphne: Are there any danger signs for the economy?

Scott: The biggest concern for the U.S. is that at least some of the economic recovery we have had since 2009 has been because of the low interest rates created by the Federal Reserve bond buying program. The Fed has been tapering that program, and it is expected that it will cease by the end of the year. Because the bond buying program is unprecedented, the ending of it may have some unintended consequences.

Daphne: What does this mean for the stock market?

Scott: We believe the market is appropriately valued. Key ratios such as stock-price-to-earnings, price-to-cash-flow, and market-value-to-book-value are at or near their long-term averages. So we think historically average long-term stock returns of 10%-11% per year are a reasonable expectation.

Daphne: Does that mean that you believe stock prices will be 5% higher at year end?

Scott: The one think I am sure of is they won’t be exactly 5% higher. Forecasting market values is very difficult to do, because it’s based on short and long-term economic data, corporate performance, and investor psychology. It almost certainly will be significantly higher or significantly lower. Unpredictable events can always occur. But as a mid-point, 10% per year, or 5% per half-year, is not a bad forecast.

Daphne: I’ve read several articles that state that because the stock market hasn’t had a 10% correction in almost three years now, such a correction is due to happen in the near future. Is that true?

Scott: It is very likely that we will experience a 10% decline sometime in the next five years, because stock markets are volatile, and in most, but not all, five year periods, there is some time in which the market fell by at least 10%. But there is no due theory of market movements – it’s not like the mail, when if you haven’t received it by 3:00, the postman is due to show up in the next couple of hours. Markets don’t work in precise cycles – just because we haven’t had a correction in a few years does not mean one will happen in the next few months. A correction is as likely to happen four years from now –perhaps after the market has risen by 50% -- as it is to happen in the next few months.

Daphne: How about international stocks?

Scott: My belief is a similar long-term forecast is valid for developed market stocks. I have better long-term expectations for emerging market stocks, because economic growth rates are expected to be higher. But the caveat is emerging market equities are one of the most volatile sectors of the capital market.

Daphne: Earlier you mentioned the tapering of the bond buying program. Will that affect the bond market?

Scott: There is little doubt that at some point in the next year or two, interest rates on short and intermediate-term Treasury bonds will increase, which will cause those bond values to decline. It’s likely that prices on corporate bonds might decline slightly at that point.

Daphne: That doesn’t sound good. What should an investor in bonds do?

Scott: The first thing is to relax. When we talk about bond volatility, it’s relatively minor compared to stock market swings. For example, in September and October of 2008, when confidence in all markets was very shaky, stock markets fell by over 20%, and emerging markets fell by 40%. During those two months, the broad bond market declined by less than 4%. Moreover, recognize that if bonds decline solely because of interest rate rises, then those declines will be made up if the bonds are held to maturity.

Daphne: So it doesn’t seem that much action is needed.

Scott: The main thing is have broad diversification across various sectors of the bond market. Ten years ago, it was believed that bond diversification wasn’t that important. But just as has always been true of equity markets, over the past 5 years different bond market sectors, such as Treasuries, highly-rated corporates, high yield corporates, and international bonds, move in different directions over different time periods. That means diversification is very important.

Daphne: And that’s Market Matters. Thank you Scott, and thanks to all of you for listening. Please join us for next week’s broadcast which will focus on international diversification.