Second Quarter 2017
How a stock market surrounded by political rancor, FBI, and special prosecutor investigations, and continuing social divisiveness can produce such good returns. In addition, these results have taken place in one of the most placid financial environments we have ever seen. Given past history, we would expect political rancor to produce corresponding financial volatility.
In addition to the domestic discord, our stock market has had to contend with geo-political concerns, international terrorism, as well as the prosecution of two or three wars, depending upon how you count them. Yet American businesses are doing well and seem quite optimistic for the near future.
There is still some hope that the new Presidential administration will actually enact some of their business-friendly policies; lower taxes, less regulation, increased infrastructure spending. Any of these policies, but especially collectively, would increase our domestic growth, providing even more opportunity for profit growth. Remember, profits drive values.
So far, the stock market has done well on current trends. Yes, there has been some lessening of the regulatory burden, but mostly the market has benefited from worldwide stimulus by many central bankers and the resulting high levels of liquidity. Since the winter of 2015-2016 central bankers responding to the commodity crash began flooding the financial system with additional liquidity. Those funds have helped fuel a worldwide recovery in financial markets as well as the real economy.
Excess liquidity is also why markets have been so even-keeled. So much needs to be put to work that any downturn prompts immediate buying; and yet there is still more that seeks a return. To some extent, bonds have been acting the same way. One would think that with improved prospects for economic growth that interest rates would rise and bond prices would decline. That didn’t happen, instead bond prices rose and yields declined. Probably because all the excess liquidity need to buy bonds too. Bonds simply did not respond to economic signals, but to liquidity flows. So, what’s next? (See the next section for our forecast.)
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Why are long term interest rates so low when the “Fed” is raising them at the short end and inflation is picking up? Part of the answer, at least, is that international money flows find U.S. rates comparatively attractive; certainly, higher than those of our major trading partners. It is still odd to have seen stocks move higher in response to good and even improving economic conditions and at the same time see the ten and thirty-year interest rates decline.
International financial flow may be part of the answer, but perhaps there are other reasons as well. There are institutions throughout the world that are only allowed to invest in sovereign debt or at least held to this as a majority of their holdings. After the most recent financial crisis and the dot.com crisis of 2002, there is still a strong bias against investing in equities. And then there are cultural biases against equity investing. Some cultures around the world see investing in stocks as something approaching gambling and not prudent.
There may be one more explanation, as well, having to do with central bank activity here in the U.S. and among our trading partners. This has to do with these banks flooding the system with additional liquidity. This liquidity may be more than the real economy can use and absorb so as with any commodity that there is too much off, the price has declined. This will change, but investors may have to wait until the central bankers finally reverse course.
The U.S. Federal Reserve is reversing course, but is doing so slowly. Others, such as the European Central Bank and the Bank of Japan, have not done so yet. Eventually they will. In the meantime, our rates will be forced up modestly, but not as much as they should be. As investors, we should continue to be cautious here. This process will likely be irregular, if not tortured; Talk with Us.
If we don’t get tax reform and increased infrastructure spending, we will continue to be stuck in a slow, but steady growth economy. If we do, then the economic growth rate is likely to accelerate. Instead of around 2% growth, we could experience 3% or better. This is the hope and objective for the new Presidential Administration, but we will see.
We are investing on the basis of what we see today, with the belief that if some good things happen, it will be beneficial. We just aren’t counting on them. However, we are seeing some broadening in the economy among those companies and sectors that are doing well. In fact, we see some acceleration in some older industries and businesses. This may simply be a result of a long economic recovery gradually benefiting more and more sectors and not any expectation for further stimulus.
Even though the stock market has had a long period of success, it is hard to see anything that will derail it at this point. Although the Federal Reserve is intent upon raising interest rates, they are still low and will remain so for some time yet. Business conditions are good and getting better. Europe and many of our other trading partners have improving economies too. This all bodes well for the near future for us.
We will probably see more companies coming to the fore in our stock market. This reflects a broadening in positive economic performance to more and more sectors. At the same time, technology and new business approaches are disrupting some older businesses. One broad area that is changing rapidly is retailing. The internet has been a disruptive force that is changing patterns, behavior, and consequently, winners and losers.
The energy business is another industry that has been disrupted by a new technology – fracking. This has changed the potential supply of oil and natural gas in a major way and where energy is found. Additionally, new batteries, solar panels, windmills, and other advances are changing how and where energy is produced.
We cite these examples merely to point out that the market can be doing quite well while whole swaths of the economy are undergoing difficult changes. So, do not focus on the difficulties, there is much more that is positive
We still expect interest rates to rise, although progress has been very irregular and unpredictable. Our rates in the U.S. are being influenced by comparable international interest rates and cross border money flows. Nevertheless, progress is being made toward normalization of rates. We are still a long way from those levels that are in line with the economic strength we are seeing.
We have adjusted portfolios to benefit from improving economic and business conditions, not only in the U.S., but in many other parts of the world as well. In essence, we are all in. Money flows into the U.S. stock market has recently turned positive and confirms the good trading action we are seeing. We expect another trading leg higher.
We have also analyzed our holdings for value. We always want to be investing in companies that have supportable valuations with good future prospects. Just in case events turn sour, we want to be holding assets of value. This has always been our philosophy.
We are now over-weighting in materials, industrial, and financial sectors. Others sectors we are under or equal weighting. Our weightings are compared to those of the S&P 500 index weightings.
As opportunities arise this year we are buying some shorter-term bonds. We are finding some values in the Municipal market, both in tax-free and taxable bonds. This has and will likely continue to be a slow process. There just aren’t enough opportunities yet to meet our needs. Hopefully that will gradually change.
For asset allocation portfolios, we have recently reduced our exposure to small cap companies and put on a modest position in emerging markets. In this we are simply following where the markets are producing positive returns. Our moves here are never all or nothing, but measured.
as of 6/30/2017
|Large Cap Stocks (S&P 500)||8.2%|
|Dow Jones Industrial Average||8.0%|
|Mid Cap Stocks (S&P 400)||5.2%|
|Small Cap Stocks (Russell 2000)||4.3%|
|Barclay Aggregated Credit Index||3.8%|
“I think you have to learn that there’s a company behind every stock, and that there’s only one real reason why stocks go up. Companies go from doing poorly to doing well or small companies grow to larger companies.”
—Peter Lynch, Author, Magellan Fund Manager (Net worth $352 Million)