Quarterly Review July 2016

Market Reaches All-Time High Amid Turmoil

Sometimes you just have to shake your head. With England having voted to leave the European Union (the "Brexit"), hostilities continuing in the Mid East, negative interest rates spreading across the globe, and violent acts of atrocity occurring with seemingly increased frequency both here and abroad, the U.S. stock market has charged through bouts of volatility into all-time high territory. Bond prices have also soared, driving bond yields ever lower.

Let's take a look at how various indices fared for the past quarter and year-to-date:

​2nd Quarter
2016 Year-To-Date
​Dow Jones Industrials (the Dow)           
+ 1.4%
+ 2.9%
​S& P 500 Stock Index (S&P 500)       
+ 1.9%
​​+ 2.7%
​NASDAQ Composite
- 0.6%
- 3.3%
​Russell 2000 Index (small companies)
​+ 3.4%
​​+ 1.4%
​Dow Jones World (non-US)
​- 1.5%
- 2.4%
​10-Year Treasury Bonds
+ 3.1%
+ 8.1%
​Commodities: Dow Jones-UBS Index
​+ 16.1%
+ 20.8%
​The U.S. Dollar (WSJ Index)
​- 0.3%
- 3.7%

All index values come from the Wall Street Journal.Stock indices do not include dividend return.

Stocks offered small gains this past quarter and moved year-to-date averages up modestly. Only the tech-heavy NASDAQ and international stocks were in the red for the quarter—and were also the only two equity indices underwater at the year's midway mark. During the quarter small companies snapped back more than larger companies but still lagged behind broad larger-company indices for the year-to-date. Bonds continued on a roll, with prices advancing to reflect the Federal Reserve Bank ("the Fed") decision to back further away from the idea of increased interest rates. Commodities came roaring back this quarter as oil prices rebounded. The U.S. dollar recovered a bit during the quarter, but its advance did not make up for earlier weakness.

Where We Are Now

We live in interesting times. The good news: inflation remains very low and the economy continues to grow at a slow but positive rate. The growth rate for the first quarter was revised upward from 0.8% to +1.1%. Some economists believe the second quarter's growth rate may have been +2.5% as consumers loosened their purse strings and increased their borrowing. Two-thirds of our economy is represented by consumer spending, so when the consumer is happy, economic growth is most often the result. Interest rates are quite low and this has stimulated consumer borrowing--especially credit card borrowing. Home prices are steadily advancing in most areas, contributing to the consumer's sense of well being.

And then there is the market's valuation. By most measures, stocks have become even more overvalued (pricey) than they were at the end of the first quarter of the year. One common measure of relative stock values (that is, whether stocks are a bargain or overpriced) is the market's price-to-earnings (P/E) ratio. Current prices are compared to the past 12 months' earnings. Historically, that ratio has been in a range of around 15-16.

At the end of the quarter, the market's P/E ratio was over 24—clearly and significantly above the historic range of this gauge. This implies that either the earnings component is about to grow substantially (unlikely), or prices will be stagnant or decline (or neither of the above--more on this in a moment). Bond prices have increased to such a degree that the interest rate yields on all maturities have declined to near record lows. (As bond prices increase, the interest income they generate represents a smaller percentage of their price). Stock and bond prices have been moving in the same direction for some time—which is often not the case. Normally an advancing stock market is due to increasing corporate profits and that, in turn, is normally accompanied by increases in inflation. As inflation rises, the Fed responds by increasing interest rates. So how do we explain an advancing stock market accompanied by declining interest rates?

The answer is not really associated with great expectations for corporate profits, but rather that the interest rates of bonds and CDs have declined to such a degree as to make them unattractive to those who would seek income from their investments. One might ask the question: what else are you going to do with money these days? Holding cash means receiving virtually nothing but stability in return, and many stalwart stocks offer dividend yields far greater than most bonds. For example, whereas the yield on 10-year U.S. Treasury bonds is currently around 1.5%, the dividend yield on IBM is more than twice that—at 3.5%. Add the merits of favorable taxation on qualified dividend income and it becomes even more appealing. This is one reason the stocks of large dividend-paying companies have been in greater demand than small companies and tech companies—both of which don't normally pay as much in dividends, if any. This dynamic may continue in spite of the (over) valuation of the markets.

Although interest rates in the U.S. have declined significantly, our rates are higher than the bonds issued by the governments of many of the world's largest economies. Many of the interest rates abroad are actually negative, a mathematical reality that has many scratching their heads in wonder. This represents a source of demand for our bonds which has helped keep our interest rates low. If/when economic growth here or abroad gains traction, this would change the equation. However, it's hard to see this happening in the near future.

Looking Ahead

The effects of Brexit and realignment of the EU are expected to be muted here. Increased acts of violence and terrorism here and abroad call for increased security measures. This will likely have a somewhat detrimental effect as resources are diverted from more productive uses. Consumers may begin to spend less in the face of more unrest. Volatility may increase as we draw nearer to the November elections. With time ticking away towards the fall elections, it will be interesting to see whether there is any shift in public opinion that translates to market movement. For now, it appears we can expect a continuation in the slow economic recovery with low inflation. Market pundits expect the Fed to leave interest rates alone until at least September. Some think it will be 2017 before the Fed acts again.

We may see a modest pullback in stocks from current levels but with bonds and CDs offering a pittance of a yield, the flow of income-seeking money will probably continue to provide an underpinning of support to the markets. The polarity of the political circus may provide some erratic market movement as anticipation of the outcome of elections may change investors' outlook on the effects on the economy. Overall, however, the slow growth, low inflationary environment we currently enjoy has historically been positive for financial assets.

As always, we will continue to follow the markets closely and take appropriate actions within client accounts to manage risk and return in accordance with each client's Investment Policy Statement.

Please feel free to call with any questions or comments.

Craig S. Limoges CFA, CFP, EA  —  George Middleton CFA, CPA-PFS

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