July 2016

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Markets Continue to Deliver

After a mid-year review and a reflection on the durability and strength of this current bull market, we note the relentless determination of markets to drift higher despite the “weather conditions” of an extremely challenged global economy. The United States Postal Service has an unofficial motto: “Neither snow nor rain nor heat nor gloom of night stays these couriers from the swift completion of their appointed rounds.” This motto is an appropriate description of the U.S. bond and stock markets over the last seven years.

Annualized Seven-Year Performance Ending June 30, 2016
S&P 500 Index – 14.92%
Russell 3000 Index – 14.95%
Barclays Aggregate Bond Index – 4.58%

S&P 500 Index Seven Years Ending June 30, 2016

The news headlines continue to scream about the continuing fears of valuation, Brexit implications, leveraged balance sheets, slowing Asia led by China, currency devaluations, politics, and terrorist attacks. None of these seem to stop the markets from delivering solid appreciation. The resiliency is truly amazing and despite all of the headlines we remain sanguine.

Don’t Fight the Fed (and other Central Bankers)

Both stock and bond market bears have either been ignoring or fighting the central bankers. It is unwise to argue with the people who are willing to spend trillions of dollars, euros, yen, and yuan to stimulate their economies. What has remained clear is their resolve to stimulate their economies through whatever means they have at their disposal. Despite the fact that historically easy monetary policies may not be reviving self-sustaining economic growth as expected (they might be counterproductive), a world awash in liquidity will have consequences. So far, most of this new money is simply flowing into global asset markets.

Economist Ed Yardeni recently noted, “In U.S. dollars, the total assets of the Fed, the ECB, the BOJ, and the PBOC have increased by $1.3 trillion over the past 12 months through May. They are up a staggering $10.5 trillion since the start of 2008. Over this longer period, the 166% increase in these assets well exceeds the 15% increase in global industrial production and the 17% increase in the value of global exports. Even inflation hasn’t been boosted as much as central bankers hoped it would be with the flood of liquidity. The world CPI is up 34% since the start of 2008 through May.”

Bear Market Concerns (On One Hand…)

One of the downsides to globalization (and there are many) is the fact that both informational and economic connectivity has yielded an avalanche of news and information that markets must digest in real time. The tendency to extrapolate the latest data point into the future within a millisecond of receiving the information has proven costly for managers. Real time, short-term information has created an environment of extreme anxiety, volatility, and interestingly, bearishness by most pundits.

The bear’s concerns:

  • The market’s volatile price action earlier this year.
  • Earnings deceleration: bears are seeing risk in a stock market that is rising when earnings have been falling over the past four quarters.
  • Sick financial institutions in Europe.
  • Over-leveraged U.S. corporate balance sheets.
  • Presidential election year.
  • Global economic sluggishness, especially in Europe, Japan, and China.
  • Monetary policy error.
  • Overvaluation.
  • Duration: we are now in the 86th month of this bull market (the second longest in history); a correction is simply overdue.

    Nevertheless, both bond and stock markets are essentially at all-time highs. Rhetorical question: what if other investors begin to join the party?

    Bull Market Response (On the Other Hand…)

    Bull markets are always hard to enjoy, particularly in the news-saturated world we live in today. This has been the most hated bull market in history if measured by sentiment, doubters, and most importantly, capital flows. Netting out purchase and sales indicates that the only net buyers of corporate stocks have been the corporations themselves through stock buybacks.

    Let’s review the bullish factors that may allow the market to continue to deliver:

    The Citigroup Economic Surprise Index went above zero earlier this month, with the best reading since January 15, 2015. This indicates the recent P/E-led rally in stocks can be justified by better-than-expected economic news.

    Sentiment remains extremely bearish; this is an excellent contra-indicator.

    The U.S. economy seems to be performing better than others as measured by nearly every metric.

    The combination of low interest rates and solid employment create an adequate operating environment for companies to innovate and grow.

    Stock market leadership is progressing in textbook fashion. While volatile, the market is rotating slowly away from previous high quality, high valuation winners toward economically sensitive cyclical companies.

    The flat earnings growth for the S&P 500 Index over the last two years was largely a result of a few sectors’ drag on earnings. Energy, Materials, Financials, and Technology have faced headwinds from falling commodity prices, lower interest rates, and the strong dollar over the past four to seven quarters. These will abate as we head into the back half of 2016 and into 2017.

    Game Plan

    We continue to favor the dominance of the U.S. markets, which represent the best companies in the world. In reality, it’s hard to find a close second. Since the beginning of the current bull market on March 9, 2009, the U.S. MSCI is up 204.4% to a record high, while the All Country World ex-U.S. MSCI is up 84.4% in local currencies and 82.4% in U.S. dollars. Not even close.

    We are always mindful of the risks that investors face regarding both macro factors and individual business trends. We own high quality assets, diversified across sectors and industries, which have provided solid returns with lower volatility. We endeavor to continue this discipline and deliver solid results through difficult periods. Just like the mailman.