1st Qtr Portfolio & Market Observations 2014

Because of the recent market volatility some of our clients are asking if we think this is the end of the bull market and the beginning of a bear market. Let’s put things in perspective. The market is up over 125% since the bottom in 2009. There have been two corrections of 10% or more since then. Over the last 12 months the market was up 21.8% with nothing more than a few minor moves to the downside.

So far in 2014 we are 3% to 5% off the highs of the various indexes. Markets don’t go straight up or down. They pause and correct as they are going to new highs or new lows. For every expert who thinks stocks and the economy are going into the “tank” there is another that thinks they are going to the “moon”. There are analysts who are always negative and others who are always bullish. So you can’t listen to all the so-called experts and feel confident because you agree with one of them.

Although we are in the fifth year of this bull market it does not mean that it must end now. Markets respond to what is going on in the economy and in the country, not to the length of time of a particular cycle.

Our thoughts:

We do not believe we have seen the top of the market with the recent high of 16,631 on the DJIA for the following reasons. Certain things happen at market peaks to turn a bull market into a bear market where the averages drop significantly. They are:

  • Markets are priced expensively.
  • The economy is growing at a rapid pace with full employment and an “everything looks great” outlook.
  • Investors are overly bullish and optimistic about the stock market and the economy.

We are not seeing these conditions today:

Today’s valuations are not overly expensive. Price-to-earnings ratios of 16.35X on the past 12 months’ earnings and 15.08X on 2014 earnings are nowhere near valuations at previous market peaks. The market is slightly above fair value on an absolute basis. On a relative basis, compared to bond yields, the market is still dirt cheap. When stocks yield more than 5 year Treasuries they are very attractively priced.

Economic numbers suggest the economy is doing better, not great, but improving gradually. Forward economic indicators suggest a continuation of a growing but sluggish economy.

While the market has done extremely well over the last 5 years there are still many skeptics and cautious investors today. Typical corrections average 10% to 20%, however the last two barely exceeded 5% before reversing, and taking the market to new highs. Despite the market gaining over 100% from the 2009 low, there are still many investors who have missed this dramatic move and are waiting for a correction to get in.

Historically, stocks have provided 4% to 6% higher returns than fixed income investments over most time periods. Investors demand a higher return from stocks because there is more uncertainty and greater risk than in bonds. In order for your portfolio to earn higher returns you have to own stocks and accept some volatility. Not many investors have gotten rich without taking this risk, and even fewer got wealthy betting against the U.S. economy.

Be assured we have balanced risk and reward in client portfolios to achieve the best returns for the risk we are taking.

Market Commentary

The first few weeks of 2014 resuscitated the bears’ fervor. The equity markets posted their largest monthly decline in eight months and closed the month of January in the red for the first time since 2009. The adage “As goes January, so goes the year.” dominated the news. History buffs kept reminding us that this “rule” was proven over 70 percent of the time in the last 85 years, and warning flags started to go up once again on Wall Street. But then, after declining over 5.6% year-to-date at the close of the first trading day of February, the S&P 500 Index, comprised of the largest U.S. stocks, was able to recover its early losses and get the year back on the right track. The 1.8% quarterly gain marks the fifth consecutive positive quarter for the S&P 500 – its longest “green” streak since 2007. The Dow Jones Industrial Average, on the other hand, was unable to fully recapture its 5.2% January loss and finished the quarter with a slight decline of 0.2%. In contrast, after displaying relative strength in the first two months of the year, the NASDAQ Composite Index weakened in March, reducing its quarterly gain to 0.8%. The Russell 2000 Index, consisting of small capitalization companies, followed the NASDAQ’s suit but managed to sustain a 1.1% advance for the quarter. The S&P 400 Mid-Cap Index was the strongest throughout all three months with a final 3.0% increase. Nine out of ten sectors of our domestic economy ended the quarter in the green, though we started to see a certain shift in leadership from cyclical to more defensive sectors – something we’ll be watching very diligently in the near future.

On the fixed income side, Treasury yields remained essentially flat for the quarter and the Barclays Capital Aggregate Total Return Bond Index matched the S&P 500 with 1.8% advance. High-yield issues performed even better, rising nearly 3.0% through the first three months of the year.

Performance of non-U.S. stocks was relatively benign, with the MSCI EAFE Index finishing the quarter basically flat at 0.2%. Against the backdrop of political tension surrounding Russia’s annexation of the Ukrainian peninsula of Crimea, gold and commodities in general did especially well, surging 6.2% in aggregate.

The Economy

More than five years after the collapse of Lehman Brothers, which plunged the United States into one of the deepest post-war recessions in U.S. history, the economic sky is really clearing up. The U.S. economy continued to show positive signs of recovery in the preceding quarter. Despite a slight softness in the construction and housing area, caused by an unusually cold and snowy winter of 2014, home prices continued to exhibit strength as the Case-Shiller home price index gained 0.8% in February, and is now up 13.3% in the last twelve months. Regional manufacturing surveys improved and indicate expansion. New factory orders for durable goods rebounded 2.2% in February, industrial production posted another solid 0.6% advance, and initial jobless claims continued to show the labor market improvement, falling to the lowest level in six months by the end of March 2014. Consumer confidence beat analysts’ estimates in February as the gain was led by strong expectations in future business conditions and, most importantly, expectations for future employment. Additionally, according to a Wall Street Journal survey, CEOs’ confidence levels have also been improving. Almost half of American CEOs plan to increase capital spending this year, indicating that the long awaited rise in business investment is underway.

The final Q4 2013 GDP growth assessment, delivered by the Conference Board on March 27, 2014, was revised up from previous estimates to an annualized 2.6 percent, thus, even with the government spending cuts and the weather-induced drop in housing construction, our domestic economy managed the best second-half growth in a decade.

Those clear signs of economic recovery strengthened investors’ attention to QE tapering and its possible impact on both the economy and the stock market. At Janet Yellen’s first meeting as the Federal Reserve Chair on March 19th, the FOMC revised its forward guidance for the federal funds rate, dropping its reference to 6.5% unemployment as a barometer for where to begin raising interest rates and instead stressing the committee’s qualitative assessment of the economy. While clearly giving the Fed more flexibility, this shift briefly spooked the market for the reason that investors interpreted it as a suggestion that interest rates may rise earlier than previously anticipated. In our opinion, however, this change was a symbolically important step, but did not alter the broader outlook for policy rates, and does not reflect any change in the Fed’s policy intentions. What is equally important to specify is the fact that when the Fed discusses the topic of “raising interest rates”, it is referring to the federal funds rate, i.e. the interest rate at which institutions lend funds maintained at the Federal Reserve to other institutions. While not directly affecting other interest rates, the federal funds rate serves as a benchmark and has a profound influence on overall economic activity as its level can either help to stimulate the economy or control inflationary pressure.

Outlook

Back on March 10, 2009 equities jumped up over 6% and never looked back at the panic lows they posted the day before. Marking the fifth anniversary of the bull market, many investors wonder how much more time this bull has to run. Rather than judging this market in terms of time, we prefer to think about events that may bring it to an end, or worse, turn it into a bear market. One of those events could be an end of economic expansion or recession, triggered by tight monetary policy, high oil prices or tax hikes – but none of those events are likely to manifest themselves in the near future. Another financial panic could obviously end the bull market – but with the sane mark-to-market rules that are in place today, another panic is not likely. Finally, a huge government expansion could turn a bull into a bear as it did in the late 1960s – but the government spending as a share of GDP is now declining and the political winds are blowing in a different direction. Overvaluation is not a problem either – equities are still not overly expensive relative to fundamentals. So, while this bull market has reached a respectable age, we would argue that the age itself is no reason to worry. Even though during the first quarter the markets continue to bounce around and while a more serious pullback is possible, we continue to believe that the economic advance will translate into earnings improvement, setting the equity markets to move higher by the end of the year.

Dumont & Blake Investment Advisors, LLC

March 31, 2014

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