3Q 2014 Commentary
by Richard Siegel, CFP®
You know things are unsettling overseas when the Russian military aggression in Ukraine is second page news. Scotland almost successfully seceded from the United Kingdom and the U.S. is now fighting a new war in the Middle East. Geopolitics along with next month’s mid‐term elections is justification for increased market volatility. Fortunately, the U.S. economy is beginning to gather steam. The final GDP reading from the second quarter came in at a whopping 4.6%, the highest quarterly reading in almost three years, driven by manufacturing, exports, and business spending. Corporate earnings also came in strong at 8.4% for the second quarter, the highest reading in almost four years.
Much of the good economic news was already factored into stock prices as the S&P 500 barely eked out a positive return for the quarter. Bonds were essentially a non‐event and gold continues to disappoint as the safe haven it once was during periods of geopolitical turmoil. It is worth noting from a seasonality standpoint, that it is not unusual for equity markets to be turbulent during the September to October timeframe.
The last few months were relatively kind to U.S. large cap equities. While we mostly avoided the significant underperformance of the small cap sector, foreign stock holdings were a drag on our performance during Q3. To reiterate our thesis from past commentaries, U.S. small cap stocks look stretched from a valuation standpoint, while foreign equities look quite attractive. With the dollar at four year highs relative to other major currencies, foreign assets struggled during the period.
Although the market is still overdue for the elusive 10% correction, the underlying trend for the U.S is an improving economy and moderately strong corporate earnings. Until the Fed meaningfully raises short term interest rates and corporate earnings growth stalls, stocks remain attractive relative to other asset classes.
The chart below illustrates the returns of the S&P 500 versus the foreign stock market represented by the MSCI EAFE Index (Europe, Australasia, Far East) over the last decade. Even though foreign stocks have historically carried significantly more risk and volatility than U.S. stocks with a similar long term outcome, there have been periods of time when foreign holdings delivered tremendous outperformance.
Fixed Income Overview
Unlike the first half of the year, when bonds delivered above average returns, the last few months have been a mixed bag for the fixed income markets. High‐yield (junk bonds) underperformed based on their high correlation to small cap equities and lack of safe haven status. Consistent with the underperformance of non‐dollar assets, foreign bonds saw significant losses for the quarter. It is important to note that our strategies remain focused on medium grade corporate debt (not junk bonds) and our foreign bond exposure is primarily denominated in U.S. dollars.
The primary influence on bond prices is movement in yields. Movement in yield is driven by several factors including supply and demand, Fed policy, and economic growth. While we believe rates will be significantly higher over the next few years, demand for U.S. bonds in the face of global uncertainty could remain high, keeping the benchmark 10‐year Treasury in the 2 ‐ 3% range for the near term.
Looking broadly at the three major asset classes (stocks, bonds, and cash), stocks still look to be the most attractive of the three on a relative basis. Cash is effectively yielding 0% and will remain there until the Fed makes a change to its monetary policy, which is forecasted to take place in mid‐2015. Bonds as measured by the 10‐year Treasury are yielding 2.5% and are priced at a premium. Finally, stocks as measured by the S&P 500 are fairly valued at their historical price to earnings ratio (PE) of 16.5 times forward earnings.
It remains our contention that we are in the middle of a long term secular bull market in equities based on valuations, corporate profitability, the interest rate environment, and innovation. Like any long term trend, returns do not come in a straight line. Corrections and even recessions are not only normal during a secular bull market, but necessary as an entry point to deploy capital. It has been approximately 5.5 years since the stock market bottomed during the 2007‐2008 credit crisis. The chart below illustrates the last two secular bull markets lasting approximately two decades.
“The four most dangerous words in the world of investing are: This time is different”
‐ John Templeton