2Q 2014 Market Commentary
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By The Deighan Team
Like a great, green star burst lighting up the sky, the Dow burst through 17,000 just in time for the Fourth of July. The event marked a new high for the storied index that tracks the results of thirty US stocks, closing well above the US stock market highs of 2008. Should we be celebrating, or preparing for the inevitable decline that follows a market “melt up”? Those who have read our newsletter year after year have anticipated that our answer will be a doleful: “Neither!” Let us surprise you! We think a toast of gratitude is in order. The fact that the US stock market has risen steadily to a new high in less than six years following a precipitous free fall is a good thing. It is a well earned success. Corporations large and small had to come to terms with a very challenging environment, and most went back to basics, first retrenching and then slowly rebuilding their inventories as the end consumers rebuilt their ability to buy their products. Of course the haunting question is: Are these market levels sustainable? In the short-term, we think so. People like to chase trends both positive and negative; on that steam alone the stock market may continue its upward path awhile. However, over the longer stretch, the sustainability of the market level will depend upon corporate earnings. The next round of earnings will be telling, but we are cautiously optimistic that they will be sound given the improvements in the US economy.
Taking a look at the domestic economy, the most recent numbers were pretty bland with the US showing a slightly lower annual growth rate for the first quarter of 2014 than the previous two quarters at 2.68%. However, as much as we might like to forget it, we had a horrendous winter in 2013-2014. Now, many are looking for a much improved GDP growth rate of 4%, a better demonstration of underlying support for stronger corporate earnings. The harsh winter probably hit the early 2014 jobs numbers too, but on July 3rd the number was up dramatically reporting 288,000 jobs added. In truth, there is more to the story here. Some reports say that educators had to work far later in June than normal and that may have inflated the jobs number somewhat. Additionally, all is not rosy for jobs seekers. Many part time workers still want full time work, and many remain underemployed compared to their aspirations and educational backgrounds. This under utilization of our human resources is part of what economists call “economic slack.” And while it is certainly disappointing and harmful to those comprising the statistic, economic slack suggests we have more room to grow before growth peaks out and wage inflation marches in.
In other words, while slack may mean we have more healing to do, it also may mean that inflation will be in check awhile longer, because the real fuel for inflation is widespread wage inflation. Wage inflation is the component that really catches the eye of the Fed. If wage inflation is not occurring, the Fed is more likely to just continue its measured march to remove the crutch of quantitative easing. Forecasts have been for the Fed’s borrowing program to end mid-year 2015. However, the recent jobs number may speed things up to the end of the first quarter 2015, and, if the economy consumes its slack and starts to heat up, the next response will be interest rate hikes. If the Fed initiates interest rate increases, the good times will slow for a bit. In our last newsletter, we mentioned 1994 when the Fed increased rates five times over the course of a year negatively impacting both bond and stock prices. It was as if an overzealous greenhouse owner decided to attack a leggy petunia with an aggressive shear back. All the flowers hit the floor, but it set the stage for new and stronger growth that lead all the way to 2000.
The best scenario for a stronger economy would be for low rates to continue for a while longer allowing businesses and homeowners alike to borrow favorably. Corporate merger and acquisition activity has increased recently and it would be nice if this could continue as well. The residential real estate market has certainly had its ups and downs, but transactions have increased and prices are starting to pick up a bit.
On the international front, China’s slowing growth has stabilized, and fears of a steep decline have abated somewhat. In India, the new election has increased hopes of economic reform. Europe is still having some trouble dragging along the weaker EU members, but the European Central Bank has cut rates to negative territory to stimulate its economy. Europe remains dependent on oil and gas from the wildcard Russia. Fortunately, Europe’s energy demands are lower in spring and summer, and there are some indications that economic sanctions may be calming Russia’s territorial challenges. Additionally, Ukraine elected a pro-European candidate for President and protests were contained. Despite the troubles worldwide, the MSCI All Country World Index showed a robust return of 5.2% for the quarter giving the index a gain of 6.5% for the year with most countries contributing positively to the returns.
In sum, sure, let’s raise a glass to slowly working our way out of one of the worst financial crises in memory. While we are always cautious in our optimism, there are reasons to believe that things may continue in a positive direction for a while. Certainly, a shock to the system could have negative market ramifications. Terrorism, acts of war, a medical epidemic, or an unknown explosive hidden in the balance sheet of a major financial institution could all be problematic. Those threats are always with us. Probably, as outlined above, the most tangible real worry is experiencing too much of a good thing. Too much success too fast could lead us again into sloppy business practices and permanent wage inflation. Then, the Fed would have to actively cast out a sea anchor by raising interest rates, and while retirees may at first blush cheer for the higher investment rates, their happiness will be short lived as their real rate of return will be wiped out by inflation. We hope we march along with the tortoise and resist the dash of the hare.
So, here is the part you knew was coming: With the US stock market hitting new highs, we recently fielded a call from a thoughtful client who asked, “I’ve been thinking about these stock market levels with the Dow approaching 17,000. Should I make my charitable gifts of appreciated securities early this year? Do you think that would be a good idea? You know, just in case?” Our answer was clear, “Certainly! It is a great idea. Just make it clear to the charities that this is your 2014 gift so they won’t expect something at year end too.” Does this mean we think the end of the bull market is near? No, it does not. However, we re-balance accounts in good times and in bad, harvesting and redeploying gains. Similarly, clients who have specific plans to make gifts with appreciated securities might as well make those gifts when their securities have clearly appreciated. On the other hand, investors look at things differently. We recently received an email from a participant in a retirement plan that went like this: “I am in my mid-sixties, and will be retiring at the end of the year. I have invested my account in the Aggressive Portfolio, but think I should now move my assets to a fixed rate before retirement. How should I best do this?” We were quick to respond to the inquiry with words of caution. Swinging for the fences, otherwise known as market timing, is a bad strategy. Study after study shows it doesn’t work. Portfolios should be carefully diversified reflecting the investor’s time horizon, risk tolerance, and reward expectations. This is why we have developed tools to help our clients determine the most appropriate mix of investments for them. A retirement plan participant with a short time horizon before retirement is probably assuming far too much market risk investing in an aggressive portfolio. At the same time, going all the way to the other extreme upon entering the retirement phase of life, especially at a time when interest rates are near historical lows, is also risky. The risk in this case is living to age 93 on a fixed low rate while inflation ravages the purchasing power of the payout. Therefore, although sometimes we do feel like a broken record, we must carry on with our message of moderation and balance. The right balance of growth and defensive securities through thoughtful diversification works, and investment discipline is essential to raising the likelihood of realizing your goals. We care very much about all of our clients. Since our mission revolves around helping clients by managing their investments so they can live their best lives, we hope you agree that good advice bears heartfelt repeating.
Best wishes for a warm, healthy, happy summer!