2nd Qtr Portfolio & Market Observations 2016

Why is it that every time the market is volatile and the world seems to be in crisis mode, the response of most investment advisors is one of reassurance along the lines of “don’t panic” or “now would be a good time to buy more equities”? The reason most advisors respond this way is due to the results shown in this S&P 500 Chart.

Keep in mind we are talking about investing, not trading, and we are talking about clients and managers that invest in a diversified portfolio. If we knew how to time the market, and more importantly, consistently sell at the top and buy at the bottom, then we would be foolish not to do it. We can’t, and no one else has demonstrated that it can be done on a consistent basis. The best most advisors can do is to participate on the upside and reduce declines on the downside. The Dumont & Blake philosophy and discipline is designed to do just that.

Having a diversified portfolio gives us the ability to participate in different sectors and own different stocks within those sectors. Not taking big bets helps to reduce the risk and volatility of the portfolio, and allows us to buy some stocks that may be out of favor today but will be winners down the road. Sometimes our assessment and outlook for a company doesn’t come to fruition, but a few laggards are not going to hurt the overall performance of the portfolio.

We enhance the performance of the portfolio by owning large, medium, and small cap stocks because there are periods of time when small and medium size stocks do better than the rest of the market or when large caps outperform. A diversified portfolio doesn’t fully insulate from downturns in the market, but helps to mitigate investments doing poorly with others that are performing well. While these rudiments of portfolio management help to explain how we manage risk, it still doesn’t quite explain our response to the opening question. The answer lies in this S&P 500 Chart.

The chart shows the S&P 500 from 1960 through 2015. Highlighted are many of the geo-political and economic events that occurred over the time period. Think of each of these events as a moment in time when things looked the most bleak, dour etc. If you keep your eyes moving from left to right, you can quickly see where things have gone. One thousand dollars invested in the S&P 500 back on 12/31/1959 would be worth $31,932 on June 30, 2016 – and that is without reinvesting dividends but taking them as cash.

There is always a reason to be nervous about the world and there is always risk, but that is what drives financial markets forward and those who participate are rewarded for it. As a noted economist said, “it’s always something”.

The Markets

For most of the second quarter of 2016 the market was relatively calm. Stocks continued to rebound nicely from the initial China scare early in the year, the old “sell in May” fright did not materialize and the market posted steady monthly gains through April, May and most of June. This fairly benign state of affairs came to an abrupt halt when the U.K. decided to leave the European Union on June 23rd. The decision, which virtually nobody predicted, struck a chord of fear and uncertainty into the markets, causing an 870-point plunge of the Dow Jones Industrial Average within just two trading sessions. However, once again, the “sky is falling” crowd was proven wrong, as the markets began a quick recovery and actually finished the month and the quarter on a positive note. The S&P 500 gained +2.46% for the quarter and +3.84% for the first half of 2016. The Dow Jones Industrial Average added +2.07%, bringing its year-to-date increase to +4.31%. The S&P 400 Index, comprised of mid-capitalization companies, rose by +3.99% during the quarter and +7.93% for the year. The Russell 2000 Index, which measures the performance of small-capitalization companies, overcame the first quarter’s loss and advanced by +2.21% for the year after the +3.18% gain during the second quarter.

All the sectors of our domestic economy were positive except technology and consumer discretionary. The energy sector topped the list, rebounding strongly from the mid-January lows in oil prices.

Global stocks produced mixed returns as signs of improving economic growth were offset by fears of the aftermath of Brexit. The MSCI EAFE Index, which measures the performance of the stock markets of the world’s developed countries, fell -2.64%, extending its year-to-date loss to -6.28%. The MSCI Emerging Market Index shed -0.32% and stood at +5.03% at the end of the first six months of the year.

Bond prices rose as Treasury yields continued to decline throughout the quarter. The largest drop occurred in the last week of June, following the Brexit vote. The yield on the 10-year U.S. Treasury note closed at 1.45% on 6/30/2016, while the Barclays Aggregate Bond Index rose +2.22% for the quarter and +5.31% for the first half of the year. 

The Economy 

The majority of the economic news throughout the last three months was rather positive. In June The Bureau of Economic Analysis revised the 1st quarter GDP up to 1.1%. While the U.S. real GDP remained below 3% for an unprecedented ten years in a row, the last revision drew a much more positive picture than an initial estimate of only 0.5% back in April.

The Institute of Supply Managers showed continued modest manufacturing growth in May with the readings above the 50-threshold separating expansion from contraction.

The latest (May) job report was one of the few news items that contradicted the overall positive economic tone. Just 38,000 jobs were created in May as opposed to a forecast of 155,000, and, although the unemployment rate fell to the lowest level since November of 2007, the dip in the labor force participation was largely responsible for it.

However, according to the Department of Commerce, both household income and consumer spending rose in April and May, driving up retail sales. Consumer confidence, subdued since the end of 2015, showed major improvement in June. While consumer prices advanced in May, inflation still did not present a concern on Main Street, rising to a mild 2.2% year-over-year.

At its latest policy meeting in June, the Federal Reserve stuck to its projection of two 25 basis points interest rate hikes in 2016, but the projected path for future rates came down.  Back in March, the median forecast suggested at least 2% of rate hikes in 2017 and 2018, while now only 1.5% for the same time frame is expected.

Outlook

It has been over a year since the domestic stock markets posted new highs, and for the last twelve months the stock market has gone virtually nowhere, frustrating the majority of investors. During this time investors have seen three “V bottoms” where the market shoots down about -10% resulting in losses, only to grind right back up as if nothing happened. Also, beneath the surface, many sectors corrected significantly during the past two years: Energy: -50%, Biotech: -40%, and Small Caps: -25%. There are many reasons for this, but two main ones quickly come to mind. Firstly, we are still in a globally coordinated effort by central banks to keep rates low and therefore provide liquidity to be poured into the market. The second reason is rather psychological, but nonetheless quite important. During every recent sell-off, there was a huge rush among investors to buy protection and hedge their portfolios in an attempt to guard against the type of losses incurred in 2008. It is important to note that historically bear markets do not occur when people are fully hedged and prepared for them.

The recent drop sparked by Brexit fear may have been the last shakeout before the market finally breaks out of its fifteen month trading range. We base this observation on the velocity of the latest recovery – not only did the market fully erase all the losses in less than a week, it did so on enormous volume, showing once again that big institutions continue to support the market on declines.

Another reason for market resiliency could be the upcoming presidential election. We believe that either candidate will not be a “disaster” for the stock market, and clearly, the market itself views both of them as business-friendly.

If – or rather when – the market breaks out of this trading range, we could see the “chase” trade start to happen, when underinvested and bearish fund managers will be forced to put money to work. We have seen this happen many times in the past, especially when low interest rates make stock dividends more attractive. As ambitious as it sounds, we consider the Dow Jones Industrial Average at 20,000 a real possibility. But it is important to understand that it may not happen in a straight line, and we should expect to see corrections, pull backs and shakeouts along the way.

Dumont & Blake Investment Advisors, LLC
June 30, 2016

 

 

 

 

 

 

 

 

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