Every year financial markets find a way to surprise us. With little doubt, one of this year’s biggest surprises has been the curveball the stock market sent to the general pre-summer “sell in May and go away” axiom. After spending the winter months dormant, U.S. stocks emerged in the spring and kept fighting each week in April, May and June with a tenacity that ultimately brought a series of new highs and delivered a record sixth consecutive quarterly gain. The Dow Jones Industrial Index recovered from its first quarter’s marginal loss and ended the first six months of 2014 up 2.68% in the green. The S&P 500 Index, comprised of the largest domestic companies, expanded by 5.23% in the second quarter, finally clearing the hurdle of the 1900 mark and bringing the year-to-date return to 7.13%. The Nasdaq Composite Index advanced by 5.32% and finished the first six months of 2014 with a 7.27% gain. The Russell 2000 Index of small and medium size companies managed to increase 3.19% year-to-date. From a sector standpoint consumer discretionary stocks were the laggards while the energy and utilities sectors generated strong first half returns.
The world equity markets also participated in the second quarter rally. The MSCE EFA Index of the world’s developed economies grew by 2.95% in 2014 Q2. Emerging markets, as measured by the MSCE EM Index, gained 5.64%, erasing the first quarter loss and ended the first half of the year with 4.80% advance.
The 10-year Treasury rate began the year just over 3.0% and closed the second quarter at 2.5%. As rates declined the price rose. The Barclays Capital Aggregate Bond index added 2.04% during the second quarter and advanced by 3.93% year-to-date.
The third and final estimate of the first quarter real GDP, reported on the last week of June, really surprised on the downside. Adverse winter weather had a huge impact as the first quarter fell a revised 2.9% after rising an annualized 2.6% in the fourth quarter of last year. The latest number was significantly below market expectations for a 1.8% decline. The second estimate was a “mere” minus 1.0% annualized. The first quarter number was the weakest since the 5.4% contraction for the first quarter of 2009. A huge hit came in the consumer sector as Personal Consumption Expenditure (PCEs) growth was revised down to 1.0% from the second estimate of 3.1% to the upside. Consumers were hindered from shopping due to severe winter weather. Downward revisions to medical spending have further compressed GDP measures. However, we viewed such poor growth as an aberration from reasonably healthy underlying trends.
Fortunately, after an extreme weather-induced slowdown in the first quarter, the U.S. economy began to thaw with warmer temperatures in the spring. Most forecasters now believe that the Q2 growth will come at 3.0% or better.
Indeed, the latest national data on manufacturing showed improvement for June. Manufacturing activity expanded at its strongest rate in four years during June, as output and new orders were both notably strong. Factories are heating up as are perhaps costs for raw materials, with the latest evidence coming from Markit’s flash PMI (Purchase Managers’ Index), where readings were at or near their best levels in the 5-year history of the report.
Consumer confidence is moving steadily to new recovery highs, to 85.2 in June vs a revised 82.2 in May. This is the fourth straight month that the index is over the 80 barrier, which indicates that optimists are out ahead of pessimists.
Existing home sales jumped 4.9% in May on top of April’s 1.5% gain. This was the first back-to-back gain for this series since April and May of 2013. New home sales in May surged a monthly 18.6% rate that was far beyond expectations.
The labor market appears to be gaining momentum. Total nonfarm payroll jobs increased 288,000 in June after a 224,000 gain in May and a 304,000 rise in April. The unemployment rate surprisingly fell to 6.1% from 6.3% in May. However, the labor participation rate remained flat at 62.8%, near a 35 year low and wage growth ticked down a little from May to post a 2% year over year gain. The tepid wage growth means that inflationary pressures are likely to remain somewhat muted in the coming months.
Geopolitics has loomed large so far in 2014. Tensions between Russia and the West, after the intervention in Ukraine, have likely kept yields low by supporting a safe-haven bid for Treasuries and could ultimately push bond yields lower by hurting global growth. An Iraq-related oil price shock could have similar rate-dampening effects.
At its June 2014 meeting, the Federal Open Market Committee extended its predictable string of asset purchase reductions, tapering its bond buying by another $10 billion to $35 billion per month. As a result, it remained quite dovish in its commentary, suggesting that while QE would most likely subside by the end of the year, the rates would remain quite low for some time. Although an inflation scare poses a certain risk for the second half of the year, with wages increasing and the Consumer Price Index ticking higher, Janet Yellen, Chairman of the Federal Reserve, suggested the possibility that inflation could be allowed to run slightly above target for a time in order to pursue better results in the labor market. Obviously, we cannot predict when interest rates will start rising, but in our view it does not necessarily spell trouble for equities. Stock markets are driven mostly by fundamentals such as underlying companies’ earnings, and the improvement of global macroeconomic data supports the expectations of future earnings growth.
So far this year the stock market has hit multiple new highs but only posted modest year-to-date gains. As the Dow Jones Industrial Average makes a run at 17,000, some may worry about the next market turn. It has been over 31 months since the last meaningful pullback, so naturally there is some fear of a correction going forward. Has the market now become dangerously high and therefore destined for a severe correction or a crash? The truthful answer to this important question is that nobody can know for sure what the stock market might do over the short run. Clearly, markets move in cycles and not perpetual diagonal lines and indeed, the series of new highs are signs of a maturing bull market. However, it is worth noting that stock market peaks are a process, not an event or an instance, and even a mature stage of a bull market can carry on as long as it is supported by economic, fundamental and valuation drivers. After a 40% advance during the last year and a half, it is wise to expect the market to pause to catch its breath and regroup. On the other hand, the all-time high levels of the equity indexes do not necessarily translate into the market being dangerously overvalued at the same time. Markets typically reach new highs over time, and while rounds of profit-taking certainly may precede new peaks, selling at any of the consequent bull market highs causes investors to miss out on future gains.
Dumont & Blake Investment Advisors, LLC
June 30, 2014