Nola Kulig
Kulig Financial Advisors
Longmeadow, MA, 01116 USA
413-565-2839
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2014 Q2 Market Review: Everything Rises–Don’t Worry be Happy, or Worry a Lot?

August 11th, 2014

This month we take our regular quarterly temperature of the markets. We look at recent market results with the goal of putting them in some perspective, and to see how that experience should set our expectations going forward.

This month’s newsletter looks at the following topics:

  • 2014 Q2 Markets Review
    • The Bull Market Marches to New Highs
    • Why Europe Matters
    • Keep an Eye on the US Economy
    • Portfolio Implications

2014 Q2 Markets Review

The Bull Market Marches to New Highs

Market reviews are great for keeping us honest as we witness the twists and turns in economic news and market results. You may recall from our first quarter commentary that there were three major themes that dominated headlines early in the year: emerging market jitters early in the quarter, Russia’s incursion into Ukraine, and a long and brutal winter that negatively impacted economic results at home.

When you look at the returns which follow, it is worth recalling that many market forecasters believed that the market “had” to fall in 2014 following a great year for stocks in 2013. Just goes to show that those shorter term moves continue to be hard to predict, and that they are not something around which to structure your portfolio.

The markets shook off all those uncertainties then some. Overall observations for the quarter and year-to-date include:

  • June was a great month for stocks, ending a really fine quarter.
  • Long term bonds and REITs were especially rewarding.
  • Emerging markets made a strong comeback.
  • Gold made a comeback with reduced competition from interest-bearing securities; since gold pays no interest or dividends, lack of income alternatives make it less costly to hold. Geopolitical concerns also played a role in gold’s rise.

Market Returns

Market

Index

June

Q2 2014

YTD
3-31-2014

Stocks        
Large Cap S&P 500 Index

   2.1%

5.2%

7.1%

Midcap S&P Midcap

4.1

4.3

7.5

Small Cap S&P Small Cap

4.7

2.1

3.2

Non-US Developed Markets MSCI EAFE

1.0

4.1

4.8

Emerging Markets MSCI Emerging Mkts.

2.7

6.6

6.1

US Bonds Barclays US Aggregate

0.1

2.0

3.9

REITs S&P US REIT

1.1

7.0

17.6

MLPs Alerian MLP

5.9

14.2

16.3

Gold Dow Jones-UBS Gold Sub index Total Return

6.1

3.0

9.9

Commodities Dow Jones-UBS Commodity Index TR

0.6

0.2

4.7

Sources: AJO Partners, Factset, Dow Jones Indexes

Everything is up in price to varying degrees. Why should this be so?

In a word, Federal Reserve policy. One controversial tool the Fed has used to keep interest rates low has been the purchase of longer-term Treasury bonds and mortgage-backed securities (bonds and yields move in opposite directions). During 2013, the Fed bought $85 billion in bonds each month with freshly minted money, but it has been cutting back at regular intervals. As of the Fed’s late June meeting, it’s now buying $35 billion per month and will probably cease its purchases in the fall.

Right now, the Fed says its current plan is to keep interest rates at rock bottom levels for a considerable period of time. Even after the first increase, rate hikes are expected to be gradual.

It’s a plus for stocks, which don’t have the competition from the low rates of return on money markets, T-bills, and other safe fixed income investments, but it punishes savers and encourages a “reach for yield” in riskier investments (like high yield bonds, not shown in our table).

Jeremy Siegel, a well-respected professor of finance at the Wharton School of Business and a market bull, offered his take in an early July interview on CNBC.

Investors are looking for yield and want to go to dividend paying stocks, which now are yielding 3-4% and more, which is well above the Treasuries and well above the money markets. I think that’s going to be a steady flow of demand for the next several years from the public.

It’s the current level of low interest rates that argues for a bullish stance, according to Seigel, though he does see some risks to the outlook.

Siegel said possible pitfalls that aren’t priced in include the potential for higher inflation. He believes that wage gains that aren’t matched by productivity increases, or much higher oil prices, could be a problem. Currently, wage gains haven’t been very impressive for most folks, but oil has the potential to be an unwanted wild card.

Why Europe Matters

The reduction in Fed cash flowing into the financial system seems to have slowed the bullish juggernaut during much of the first half of 2014. But as the Fed has been cutting back, a new kid in town has emerged–it’s called the European Central Bank (ECB). Like the Fed, it has the potential to create cash out of thin air and buy up debt.

Unlike the U.S., Europe is struggling with a rate of inflation that is too low. That doesn’t sound like a problem to most consumers, but Europe isn’t far from slipping into what is called “deflation,” or a general decline in the price level.

Sure, it sounds enticing. Who wants to pay more when you can pay less? But in reality, most economists view deflation as an economic black hole. It causes consumers and businesses to delay purchases, as they expect prices to decline further. It also makes the cost of carrying debt onerous. The two forces can contribute to a vicious cycle of declining economic growth, as some of the peripheral European countries have already experienced.  A look at Japan’s experience over the last 20 years also offers up a sobering example.

This matters because the ECB took modest unconventional measures at its June meeting. More importantly, central bankers in Europe continue to hint that they may begin a U.S. style program of buying longer-term bonds, encouraging investors to jump into stocks throughout the month of June.

Keep an Eye on the US Economy

Job growth has accelerated markedly in recent months, yet economists are estimating that GDP stalled in the first half of 2014. We may eventually see upward revisions to recent data that have been suggesting consumers are in no mood to spend.

I’m cautiously optimistic that recent jobs gains will power consumer spending in the second half of the year. But if growth does not accelerate, the Fed could hold interest rates at near zero for even longer than many anticipate. There is no real way to tell in advance how things will play out.

Portfolio Implications: Investor Know Thyself (and Thy Plan)

1. Stick with your plan

We touch on this point every quarter, but we can never say this enough. Your goal is to obtain a particular financial objective, and I am here to advise and assist as you travel on your financial journey. Yet we want to be careful that you do not take too much risk for your particular situation.

A number of variables go into the risk equation as we craft a portfolio that helps you meet your objectives without taking undue risk. We don’t want you to experience sleepless nights generated by market storm clouds.  A balanced portfolio helps to manage risk.

2. Don’t change your risk tolerance along with the rise in the market (or from fear it might fall)

It is easy to become complacent or overconfident as markets rise, which means we may want to increase our risk. Your portfolio should be crafted (and maintained) with a realistic level of risk, which is what you can tolerate in a poor market, but no more than that. Those who significantly increase risk as markets rise, usually live to regret it.

On the other hand, if we are fearful markets could fall because they have risen so far so fast, we can talk ourselves into the opposite problem. We then become fearful to invest, and if markets continue to march on, we back ourselves into a corner. Far better to commit to a program that fits your risk profile and financial capacity than to forever sit on the sidelines.

3. Rebalance

Anytime we see a big run-up in equities, some of our clients exceed their target asset allocation for stocks. In order to reduce significant fluctuations in your portfolio, we recommend that clients who exceed their targets reduce their exposure to stocks.

If your personal situation has changed, let’s talk and see how we might be able make some adjustments. Options may include a more conservative stock selection or possibly reducing the equity weightings. It may reduce the upside, but managing risk is a critical component of any investment portfolio.

I hope you’ve found this review to be both educational and helpful. If you have any questions or would like to discuss any matters, please feel free to give me a call.

As always, I’m honored and humbled that you have given me the opportunity to serve as your financial advisor.

Investment advisor representative of an investment advisory services offered through Garrett Investment Advisors, LLC, a fee-only SEC registered investment advisor. Tel: (910) FEE-ONLY. Kulig Financial Advisors may offer investment advisory services in the state of Massachusetts and other jurisdictions where exempted.