2015 3rd Quarter Outlook

July 10, 2015

Review of 2nd Quarter

 

 

 

 

 

 

 

 

 

 

 

Given the high level of market volatility at the close of the second quarter, it’s interesting to consider that overall market returns for the quarter were very mild. Both U.S. large company and small company stocks were flat, and both international developed markets and emerging markets increased in value by a mere 1%. Conversely, bonds declined in value by 2%, caused by concerns that the Federal Reserve will increase interest rates in the next few months.

 

U.S. Economy

Below is a table showing key economic and market indicators (as of June 30)*:

 

 

 **Sources: Bureau of Economic Analysis, Bureau of Labor Statistics, JP Morgan, Federal Reserve Board

 

These data suggest that the factors affecting the broad U.S. economy remain solid – slow and steady growth, increasing employment, and low inflation. The consistency in the economy explains the low change in market values for U.S. stocks. We agree with the market consensus and remain bullish on the U.S. economy. 

 

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U.S. Stock Market Outlook

As we explained last quarter, a belief that the economy will continue to grow does not necessarily imply that stocks will continue to rise. While market valuations are not overly high, they reflect the current state of the economy. Unless there’s a spectacular influx of growth in the economy, it’s likely that market returns will remain unspectacular. Moreover, there are several independent risks that could cause ripples in the stock market:

 

  • Earnings: Very few analysts expect an increase in the price-earnings ratio (valuations as a multiple of earnings). This means stocks will increase in value only if earnings continue to rise. Hence, a slippage of earnings will likely cause stocks to decline. We saw this behavior in late April and May, when each day’s stock market return was highly sensitive to the corporate earnings announcements of that day. We expect the same behavior over the next couple of months.

  • Interest rates: Most analysts are expecting rates to rise, so the impact of such an increase in rates will likely not be severe. But, if rates rise faster and higher than expected, it wouldn’t be surprising to see a decline in equity values.

  • Greece: In 2011, we opined that the potential impact caused by the Greek crisis was overstated, and consequently the enormous volatility during that time would soon dissipate [Greek Economy & Shark Attacks]. Four years later, the volatility of the impact of the crisis is far less severe, and we still believe it’s overstated (our central point today, as it was then, is that Greece makes up less than 0.3% of the world economy). Nonetheless, we’re still likely to see heightened daily market movements over the next few weeks, and even months, until the situation is resolved.

  • China: As of June 5, Chinese stocks (based on the Shanghai Stock Exchange index) had increased in value by nearly 150% over the past year, which caused many to question whether that market had become a highly overvalued bubble. In the month since then, it’s declined by 26%, but to put it in perspective, an investor in Chinese stocks over the past year still earned a juicy return of 80%. However, the recent volatility in Chinese stocks has impacted the U.S. market. While China has a larger impact on our economy than Greece, the volatility is affecting only the Chinese stock market, and not necessarily the broad Chinese economy.


We’ll discuss the implication of these risks in our summary below.

 

Bond Market

We’ve been warning about the potential decline of the bond market for a couple of years. And last quarter we were correct. We’ll likely see more increases in yields and declines in bond values, but until money market yields rise significantly, we don’t think you should abandon the bond market. Instead, you should diversify much of your portfolio away from Treasury bonds and indexed bond funds, and include other types of bonds such as investment grade corporate, high yield, and emerging market debt. We also recommend staying away from long-term bonds, which are more sensitive to interest rate increases.

 

 

International Stocks

Certainly the next few weeks and months will be highly volatile for non-U.S. stocks. That being said, international equities still play an important diversification role for portfolios, and we recommend continuing to hold onto your current international holdings. 

 

 

Summary

There are many reasons to suspect that equity markets will be somewhat more volatile over the next few months than they have been over the past three years. But this doesn’t mean you should reduce your allocation to equities – merely that you should adjust your expectations. Over the past 2 ½ years investors in U.S. stocks have been spoiled. We’ve enjoyed great returns with virtually no volatility (the S&P 500 has not lost money in any of those 10 quarters). On average, the likelihood of a losing quarter is only slightly less than 50%, so in essence, we’ve flipped a coin 10 straight times and seen nothing but “heads.” So as we move forward, we know we’re likely to see some “tails,” somewhat higher volatility, and occasional market declines – in other words, a normal stock market. Remember that over the past 90 years, those normal markets have risen by an average of 10% per year despite the volatility and intermittent dips in prices. ​

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