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Quarterly Newsletters Archives - Pinnacle Investment Management, Inc.

Third Quarter 2018

October 5, 2018 / Quarterly Newsletters

US technology and small company stock indexes advanced strongly this quarter while international stock indexes, especially emerging markets lagged. In what could be considered a “tale of three markets” many US technology and small company stocks indexes achieved double digit returns the first nine months of the year, while many international developed country indexes declined modestly and some emerging market indexes posted double digit declines. As a result of losses in the international markets, global / world stock indexes only posted low single digit returns for the nine months.

The US advance was spurred by strong corporate earnings, lower corporates tax rates, rising consumer confidence, low unemployment, and a significant increase in companies buying back their own stock with cash savings from lower tax rates.   Weak international results arose from threats of increased US tariffs, a rising US dollar and concern that a number of emerging market countries had incurred too much US dollar denominated debt at a time the US dollar was strengthening and their economies were weakening.

The Federal Reserve has raised short term interest rates three times (to a range of 2.0% to 2.25%), an indication that the Fed believes the US economy is making progress toward its objectives of full employment and price stability. Economists expect the Fed will raise rates one more time in 2018 and continue raising them in 2019.  As a result of a strengthening economy the interest rates (for all maturities) have begun increasing more rapidly.  The interest rate on ten year US Treasury bonds rose from 2.4% at the beginning of the year to more than 3%.  Rising interest rates create a headwind for bond investors and the US aggregate bond index lost 1.7% in the first nine months of the year.

Returns for key indexes were:

 
1st Qtr

2018

2nd  Qtr

2018

3rd Qtr

2018

9 Months

2018

Dow Jones Industrials index 2.0% 1.3% 9.6% 8.8%
S&P 500 index 0.8% 3.4% 7.7% 10.6%
NASDAQ 2.3% 6.3% 7.1% 16.6%
S&P 400 mid-cap index 1.2% 3.9% 3.3% 6.1%
Russell 2000 small-cap index 0.1% 7.9% 3.6% 11.5%
Total International, excluding US 0.2% 3.3% 0.3% 3.2%
Dow Jones Global Stock index 1.4% 0.1% 3.4% 1.8%
Barclays US Aggregate Bond index 1.5% 0.2% 0.1% 1.7%

 

Economic and Market Outlook         The US economy remains strong, growing over 4% in the second quarter. US unemployment remains a low 3.9%, in contrast to more than 8% across Europe and 5.8% in Canada.  However unemployment varies widely by country.  Germany and Mexico are 3.4%, Japan and Switzerland are running 2.4%, and Singapore 2%.  Unfortunately unemployment is running above 10% in Italy, above 15% in Spain and above 20% in Greece.

Strong US economic growth and low unemployment is reflected in American consumer confidence which rose to its highest level in 18 years in August.

The recent reduction in the US corporate tax rate is contributing to positive earnings growth and US corporate profits are expected to grow nearly 20% this year, making US stock valuations more attractive. Corporations have used at least some of their earning to buy back their own shares as share buybacks increased 50% in the first half of the year.  These buybacks provide a boost to share prices since they increase earnings per share (fewer shares outstanding) and the demand for their stock.

As a result of the strong economy, significantly lower corporate income taxes and strong earnings growth the S&P 500 index achieved new highs during the quarter and had its best quarterly gain since 2013.

In spite of the underlying economic strength, there are reasons for caution. Interest rates are rising across the board and the increases seem to be accelerating.  Rates on two year US Treasuries have increased from 1.89% at the beginning of the year to 2.81% while rates on ten year US bonds have risen from 2.4% to more than 3%.  Although the twelve month inflation rate was only 2.7% (through August), that will likely increase and a significant jump would raise concerns for investors and could lead the Federal Reserve to increase interest rates more quickly than expected..

The potential for escalation of US trade disputes present another reason for caution. If US tariffs lead to a full scale trade war there will no victors; all countries would incur economic damage.  While most political pundits believe that it would not make sense for the current US administration to prompt a trade war prior to the November election, there seems to be a widespread agreement that the current administration can be unpredictable and does things difficult to understand and not always in their own best interest.

Other factors may also impact the market. The most likely scenario for the November election is the Republicans retain control of the Senate but the Democrats achieve a majority of the House.  Such a scenario would likely produce more gridlock in Washington, which may be positive for the stock market.  The Mueller investigation may still go in unpredictable directions and create even more serious legal problems for the Trump administration; however this could potentially impact the markets in either a positive or negative manner.

Famous people who died without a Will include Picasso, Howard Hughes, Prince, Michael Jackson. Sonny Bono, Jimi Hendrix, Abraham Lincoln, Martin Luther King and Aretha Franklin. When someone dies “intestate” the laws of the State where they resided dictate the disposition of their assets, thwarting any wishes they may have had, and making it more difficult for their children or spouses to settle the estate.  While each of these individuals had many admirable qualities, the failure to put together an estate plan was not one of them.

Free Credit Freeze       It is now free to freeze your credit report.   A credit freeze makes it difficult, if not impossible, for someone to fraudulently open credit in your name.  We strongly recommend that you and everyone in your family (including minor children) freeze their credit.  The process of freezing your own credit is easy and can be done on-line at each of the three credit agencies (Experian, TransUnion and Equifax).  It is also very easy to temporarily unfreeze your credit when applying for a credit card, mortgage, etc.  It is more challenging to freeze your children’s credit since it involves mailing documentation to the credit agency.  However due to an increasing number of ID thefts victimizing children, freezing their credit is still recommended.  Please let us know if you have any questions or we can help.

The Financial State of the States  “Truth in Accounting” released its most recent “report card” on the financial condition of the states.  States who passed with flying colors were AK, ND, WY, UT and ID.  Those failing miserably are NJ, CT, IL, KY and MA.  NJ scored dead last with liabilities of $61,400 per tax payer, with CT next to last with $53,400 per tax payer.  In contrast, first place AK has net assets of $56,500 per tax payer while SD has net assets of $24,900 per taxpayer.


Second Quarter 2018

July 11, 2018 / Quarterly Newsletters

The first half of 2018 was bumpy for financial markets as trade tensions took their toll.  The S&P 500 began the year with its best start in over 30 years.  It gained 7% the first three weeks before encountering the fastest 10% decline since the 1920’s but rebounded to close the first half of the year with a gain of 2.7%.  International markets experienced a similar ride during the first quarter, but due to escalating trade tensions did not rebound, and in aggregate lost 3.5% during the first half of the year.  Emerging markets were impacted even more by rising trade tensions, and on average declined nearly 9% during the recent quarter.  The best performers were US Small companies and technology stocks which would not be impacted as much as large industrial firms in the event of a trade war.

 

The Federal Reserve raised short term interest rates by 0.25% in both March and June (to a range of 1.75% to 2.0%), an indication that the Fed believes the US economy is making progress toward its objectives of full employment and price stability. Many economists expect the Fed will raise rates one or two more times in 2018 and continue raising them in 2019.  As a result of a strengthening economy the interest rate on ten year US Treasury bonds rose from 2.4% at the beginning of the year to 2.8%.  Rising interest rates create a headwind for bond investors and the US aggregate bond index lost 1.6% in the first half of the year.

 

Returns for key indexes were:

  1st Qtr

2018

2nd Qtr

2018

1st Half

2018

Dow Jones Industrials index 2.0%   1.3% 0.7%  
S&P 500 index 0.8% 3.4% 2.7%  
NASDAQ 2.3% 6.3% 8.8%  
S&P 400 mid-cap index 1.2% 3.9% 2.7%  
Russell 2000 small-cap index 0.1% 7.9% 7.7%  
Total International, excluding US 0.2% 3.3% 3.5%  
Dow Jones Global Stock index 1.4% 0.1% 1.5%  
Barclays US Aggregate Bond index 1.5% 0.2% 1.6%  

 

 

 Economic and Market Outlook   The recent reduction in the US corporate tax rate is contributing to positive earnings growth and US corporate profits are expected to grow nearly 20% this year, making US stock valuations more attractive.

 

The US economy appears healthy and resilient, and economic growth is improving.  Interest rates remain low by historic standards and the US job market continues to strengthen.  Although employers hired 213,000 workers in June, 600,000 new workers reentered the workforce, so ironically unemployment rose to 4.0% from 3.8% in May, the lowest level since April 2000.  (The lowest unemployment rate in US history was 2.5% in May and June 1953.)  The Federal Reserve’s goal is to raise interest rates sufficiently to avoid inflation but without increasing unemployment or tipping the country into a recession and so far they are on track.  Inflation is currently running approximately 2%, which is the Fed’s target.  However new trade tariffs will increase costs to consumers and businesses.  If inflation creeps higher the Fed is likely to raise rates faster.

 

In addition to raising interest rates, the Fed is accelerating its reduction of the $4.5 trillion in US Treasury and mortgage securities they acquired during the financial crisis under a program termed QE (“Quantitative Easing”).    Some economists have concluded that QE had very little effect on the economy so it is reasonable to conclude that the QE reversal will also have limited impact.

 

The Fed Reserve’s moves to increase short term interest rates, the reversal of QE and a strong labor market, make it extremely likely that both short term and long term interest rates will continue to rise through 2018 and into 2019, creating a headwind for both stocks and bonds.

 

Although the US economy is growing, there is a good deal of economic and market uncertainty resulting from US trade policy. Arguably every respected economist believes that free trade is vital for economic growth and that raising tariffs are likely to increase costs for consumers, stifle economic growth and result in counter-tariffs being imposed by countries importing US merchandise.  While it is unlikely that every trade agreement the US has entered into is equally fair to both parties, imposing new tariffs will likely upset the equilibrium and lead to undesirable consequences.    Harley Davidson’s announced plans to move some production overseas to avoid European tariffs imposed in retaliation of the new US tariffs on steel and aluminum is a visible example of the unintended consequences that may result from imposing new tariffs.  Investing during a period of rising tariffs is very challenging since it is impossible to know which products might be targeted, how low long the tariffs will last, and their impact on complex global supply chains.  As a result, market volatility is likely to continue for as long as Washington’s policies threaten free trade.

 

While there is likely to be differences of opinion as to whether a particular trade agreement is fair to both sides, there are unlikely to be differences of opinion whether it is fair for one country (such as China) to use espionage, counterfeiting and hacking to steal trade secrets and intellectual property. It is very important to US corporations and our national security to find a way to halt these practices.

 

A new concern is that the difference between short term and long term rates is small and continuing to narrow. When the economy is growing, the rate on longer term bonds are typically higher than short term ones to provide investors with additional compensation for the risk they are taking.  Historically when short term rates exceed long term rates (sometimes termed an “inverted yield curve”) it has often preceded a recession by six to 24 months.  According to the NT Times, this has occurred in advance of each of the 9 recessions since 1955 and has only provided one false positive.  Currently the difference between the yield on two year US government bonds and ten year bonds is only 0.3%.  It will be prudent to keep our eyes on interest rates.  Even if the yield curve does invert, it is important for investors to remember that recessions do not necessarily result in a bear market.

 

Both developed and emerging overseas markets are more attractively valued than the US. While international stocks would also likely suffer in a trade war, the valuations make them attractive.

 

The US Treasury uses “Enron like Accounting” for our national debt.   According to official figures, the US National Debt stands at a relatively high $21 trillion or 108% of our GDP.  But according to the non-profit “Truth in Accounting” government reporting is similar to the infamous Enron accounting methods which omitted huge liabilities.  While the US Treasury reports our current debt at more than $21 trillion, this is only correct if you believe that our veterans and Social Security participants are not owed all the retirement benefits they have been promised.  If unfunded Social Security and Medicare liabilities as well as veteran retirement benefits are included, our national debt increases fivefold to more than $104 trillion.  The current accounting method works well for elected officials who want votes and make promise,  however it obscures growing financial problems down the road.

 

Scammers are always on the prowl, both on-line, on the phone, in person and by mail. So be careful.

  • Always verify a caller’s identify before providing any information. The IRS does not initiate contact by phone.
  • Monitor credit card bills and bank statements for erroneous charges
  • If there is a possibility that your personal information has been compromised, freeze your credit
  • Do not click on any email links unless you are absolutely certain it is from a legitimate source
  • If you see a “pop up” message that your computer has a virus, it is likely to and an attempt to have you call a phony “support” number. Simply close that window and clear your browser’s history.
  • If you believe that your bank or investment account data has been compromised, notify the financial institution.

First Quarter 2018

April 6, 2018 / Quarterly Newsletters

Global equity markets began the year on a strong note, but quickly reversed course as economic and political uncertainty led to market volatility.  Most equity markets ended the quarter with small losses as investors became concerned that the course of the Mueller investigation, rising interest rates and the possibility of US tariffs would lead to a trade war.  After a “Goldilocks” 2017 with attractive returns and low volatility, equity markets appear to have returned to a normal state, where temporary declines of 5% to 10% in an otherwise rising market are routine.  The S&P 500 index declined 0.8% for the quarter, while a broad index of foreign markets declined 0.2%.  Emerging Markets, especially Brazil and Thailand posted the strongest international advances while India and Canada suffered declines.

 

In 2017, there were only eight days in which the S&P 500 moved up or down by 1% or greater.  (Four days were advances and four were declines).  In 2018 that was tied in early February and more than doubled in the first three months of the year.

 

The Federal Reserve raised short term interest rates by 0.25% in March (to a range of 1.5% to 1.75%), an indication that the Fed believes the US economy is making progress toward its objectives of full employment and price stability.  Many economists expect that the Fed will raise rates two more times in 2018 and continue raising them in 2019.  As a result of a strengthening economy the interest rate on ten year US Treasury bonds rose from 2.4% at the beginning of the year to 2.7%.  Rising interest rates created a headwind for bond and stock investors and the US aggregate bond index lost 1.5%.

 

Returns for key indexes were:

Full Year

2017

1st Qtr

2018

Dow Jones Industrials index 28.1% 2.0%  
S&P 500 index 21.8% 0.8%  
NASDAQ 28.2% 2.3%  
S&P 400 mid-cap index 14.5% 1.2%  
Russell 2000 small-cap index 14.6% 0.1%  
Total International, excluding US 27.5% 0.2%  
Dow Jones Global Stock index    21.8% 1.4%  
Barclays US Aggregate Bond  index    3.6% 1.5%  

 

Economic and Market Outlook   The reduction in the US corporate tax rate in 2018 is contributing towards very positive earnings growth.  It is estimated that US corporate profits will grow an estimated 15% to 20% this year making US stock valuations more attractive.  Since it is unlikely that tax rates will be lowered any further, this should be considered a one-time boost to earnings.

 

The US economy appears healthy and resilient, although economic growth remains sluggish.  Interest rates remain low by historic standards and the US job market continues to strengthen.  Unemployment is 4.1%, the lowest level in seventeen years.   Inflation, which often moves in the opposite direction of unemployment, still remains low.   It is somewhat unusual to have low unemployment combined with low inflation.  The Federal Reserve’s goal is to raise interest rates sufficiently to avoid inflation and an “over-heated” economy yet without raising unemployment or tipping the country into a recession.  Historically this is a task that has not been easy for the Fed to do and a miscalculation may pose a risk to the economy and the financial markets.

 

In addition to raising interest rates, the Fed is reducing the $4.5 trillion in US Treasury and mortgage securities they acquired during the financial crisis under a program termed QE (“Quantitative Easing”).  QE had never been tried before and there are significant differences of opinion among economists as to what the impact (if any) of QE has been so it is also not clear what the result of the QE reversal will be.

 

The Fed’s moves to increase short term interest rates, the reversal of QE and a strong labor market, make it extremely likely that both short term and long term interest rates will continue to rise through 2018 and into 2019, creating a headwind for both stocks and bonds.

 

Although the US economy is growing, there is a good deal of political, economic and market uncertainty resulting from a host issues, including:

 

  • Will the Federal Reserve’s moves to raise interest rates lead to a recession?

 

  • Will the recent imposition of US tariffs lead to a trade war?

 

  • Will the “Facebook backlash” resulting from a data breach cause significant changes in user behavior and / or spill over to other technology or social media firms?

 

  • Will the Federal Reserve’s actions to reverse Quantitative Easing (by not purchasing new bonds as their current holdings mature) lead to any unintended consequences?

 

  • Will the continuing shake ups in the White House lead to decisions or statements which may jolt the financial markets?

 

  • What course will the Mueller investigation (and other legal issues facing the President) take?

 

  • Will the S&P 500 be able to continue its winning streak and advance for ten years in a row?

 

Future long term US economic growth will be significantly limited by the anticipated very low growth in the US working age population (both natural born and immigrants).  This could be remedied by increasing immigration but that appears to be unlikely given the current political climate.

 

Both developed and emerging overseas markets are more attractively valued than the US.   The S&P 500 index is currently valued at about 16.1 times anticipated 2018 earnings, in line with their 20 year historic average.  In contrast, a popular index of international stocks is currently valued at about 13.3 times expected 2018 earnings, below the US,  and also below the 20 year average of 14.5 for the same index.  While international stocks would also likely suffer in a trade war, the valuations make them compelling investments.

 

In spite of the risks mentioned above, the US economy should be resilient if we can side step any significant political miscalculations.  If so, the equity market is likely to advance modestly in 2018 albeit with continued volatility.

 

“Reading tea leaves” resulting from statements from the White House may be a risky business, but I suspect that the current saber rattling over tariffs and trade will turn out to be posturing and not result in a trade war.  If that is correct, any market declines following White House (or Chinese) statements regarding tariffs will represent a buying opportunity.

 

Charitable donation strategies under the new tax law  Although the new tax law changed some rules, you should not reduce donations to worthwhile causes.  Charitable donations are still deductible under the new tax code, however state and local taxes are limited to a combined deduction of $10,000 for both single and married and the standard deduction has been increased to $12,000 for singles and $24,000 for married.  It is likely that fewer people will find it beneficial to itemize, and if they don’t itemize, they may not receive a tax benefit from their donations unless they become creative.  A few strategies for optimizing tax benefits from charitable contributions include:  (1) grouping your donations (and other deductions) into alternate years (making 2 years worth of donations in a single year) so in total they exceed your standard deduction, (2) Establish a Donor Advised Fund (DAF) so you can make one large contribution which you can distribute to charities over the course of multiple years and (3) If you are over 70-1/2 donate directly from your IRA.  Whenever possible, donate appreciated securities rather than cash to avoid a capital gain tax when you sell the security.


Fourth Quarter 2017

January 11, 2018 / Quarterly Newsletters

Global equity markets enjoyed a profitable and incredibly smooth ride in 2017.   Many US and international equity indexes posted double digit gains but perhaps the most remarkable aspect of the year was the extremely low level of volatility. There has not been a 3% “correction” in the S&P 500 since November 2016, the longest stretch since the S&P 500 was established in 1957. Further, 2017 was the only year in which the MSCI All Country World Index posted positive gains every month since that index was established in 1988. The market advances have been very broad, and the vast majority of stocks benefited.

Emerging markets, especially Brazil, South Korea, Chile, and India posted the strongest gains, but Europe and the US were not far behind.

The S&P 500 index of large US stocks gained a respectable 21.8% while the Russell 2000 index of small US stocks gained 14.6%, however both were eclipsed by the 27.5% return for a market index of all international stocks and the NASDAQ return of 28.2% fueled by technology stocks. Approximately 10% of international returns arose from foreign currencies appreciating vs. the US dollar. Foreign investments which were “currency hedged” did not enjoy the extra 10% boost from their appreciating currencies. Strong growth in corporate earnings, along with anticipation of a reduction in the US corporate income tax rate helped spur the advances in the US markets.

Global equity markets advanced in spite of tensions relating to North Korea and the US political uncertainty, including the Mueller investigations into President Trump’s possible ties with Russia.

The Federal Reserve gradually raised its short term “federal funds” target rate three times, by a total of 0.75%, to a range of 1.25% to 1.5%. Short term 2 year US Treasury bonds followed the Fed’s lead and rose from 1.2% at the beginning of the year to 1.9% by year-end.

The Fed also began reducing the $4.5 trillion in US Treasury and mortgage securities they acquired during the financial crisis. They will initially reduce bond holdings by $10 billion per month and gradually increase that to $50 billion per month. If anything, this planned reversal of QE (quantitative easing) would be expected to increase long term rates, but to date that has not happened. In fact, interest rate on long term ten year US Treasury bonds closed the year at 2.4%, slightly lower than the 2.45% a year earlier.

Bonds achieved modest returns for the year. with the US Aggregate Bond Index advancing 3.6%

Returns for key indexes (including dividends) were:

 
4th Qtr

2017

Full Year

2017

Dow Jones Industrials index 11.0% 28.1%
S&P 500 index 6.6% 21.8%
NASDAQ 6.3% 28.2%
S&P 400 mid-cap index 5.8% 14.5%
Russell 2000 small-cap index 3.3% 14.6%
Total International, excluding US 4.8% 27.5%
Dow Jones Global Stock index 5.5% 21.8%
Barclays US Aggregate Bond index  0.4% 3.6%

 

Economic and Market Outlook    Although growth is slow, the US economy appears healthy and resilient. Interest rates remain low by historic standards and US unemployment is a low 4.1%.

The complexity of the recent US tax legislation makes it difficult to forecast its overall impact. Anticipation of the significantly lower corporate tax rates provided catalysts for the stock market advance and will help US corporations remain competitive internationally. Changes in the personal income tax will impact people differently, depending upon where they live and how they earn their living. Individuals living in states with high income and property taxes will not fare as well as those who do not. Individuals who are sole proprietors or owners of “pass through” entities such as LLC’s (limited liability companies) or “subchapter S” corporations will likely see their taxes lowered. CPAs and attorneys who can help individuals advantageously navigate the new regulations will benefit. Future generations of US taxpayers will face a higher national debt.

In spite of their 2017 advances, foreign stock markets, especially emerging markets remain more attractively valued than the US, and should produce better returns over the intermediate term. Of course they are also subject to more political and currency risk than US stocks.

Most economists expect interest rates to continue to rise, which will reduce the value of existing bonds. This will impact long term bonds more than short term bonds. If the increase is slow, as expected, it will present a mild headwind for fixed income investors but most bonds (and bond funds) should continue to produce positive returns as interest income more than offsets the loss in value. A significant increase in interest rates would likely produce volatility in the stock and bond markets. In addition to the risk of rising interest rates, significant increases in inflation or indictments in the Mueller Russian investigation could produce volatility in the financial markets.

We remain cautiously optimistic for 2018, but feel it unlikely that the “Goldilocks” environment of high returns and low volatility will persist through 2018. Single digit returns in the equity market and a 10% “correction” would not be surprising.

The US National Debt represents money the federal government owes to others. According to a recent Wall Street Journal article, our debt currently stands at 108% of our GDP (gross domestic product), not including unfunded Social Security and Medicare benefits. Studies have shown that in countries which have incurred national debt in excess of 90% of GDP, economic growth slows by 1% per year for 20 years, resulting in fewer jobs, lower salaries and lower growth of corporate profits. Some countries are in worse shape than the US. Japan’s national debt is in excess of 240% of GDP, Greece is 180%, Italy’s is 133% and Portugal is 125%% The US was not always such a debtor, however the 2009 stimulus package resulted in nearly $1 trillion of additional spending and the recent tax legislation will result in $1.5 trillion in increased deficit spending over the next ten years.

Bitcoin has been in the news as the reported value soared from under $1,000 at the beginning of 2017 to over $14,000 at year end. It has very little of the merits of traditional investments and, in spite of warnings from the likes of Warren Buffet and Jamie Dimon of JPMorgan, some buyers do not seem deterred. If you feel a need to partake in what seems to be a very speculative purchase, we advise to do it with your “play money”. Treat it like a trip to Las Vegas, for entertainment purposes only, and not with your “serious money”.

Pinnacle is proud to have joined Mercer Advisors and believe their commitment to serving clients as a fiduciary, along with their technology, administrative and financial planning resources will enable us to do an even better job serving our clients.

 


Third Quarter 2017

October 5, 2017 / Quarterly Newsletters

Global equity markets continued their upward trend in the third quarter. As in the first half of the year, international stocks, especially Brazil, Chile, Russia and other emerging markets led the way. The S&P 500 index of large US stocks gained a respectable 4.5% and the Russell 2000 index of small US stocks gained 5.3%.

Equity markets advanced in spite of tensions regarding North Korea and the uncertainty of whether US tax reform will be passed, and if so, what form it will take.

International returns were helped as foreign currencies strengthened about 3% on average compared to the US dollar and 9% since the beginning of the year.

After two increases in rates earlier this year the Federal Reserve maintained its short term “federal funds” target of 1.0% to 1.25%.  The rate on long term ten year US Treasury bonds also remained relatively unchanged, closing the quarter at 2.3% slightly lower than the 2.4% in June and considerably higher than the 1.4% low last July.

The Fed also announced that this month it will begin reducing the $4.5 trillion in US Treasury and mortgage securities that they acquired during the financial crisis. They will initially reduce bond holdings by $10 billion per month and gradually increase that to $50 billion per month.   If anything, this planned reversal of QE (quantitative easing) would be expected to increase long term rates, but that has not happened yet.  Some economists believe that since most of the bonds the Fed holds are sitting as unused bank reserves, the QE reversal will have little impact on the economy or interest rates.

Bonds achieved modest returns with the US Aggregate Bond Index advancing 0.7% during the quarter and are now up 3.1% since the beginning of the year.

Returns for key indexes were:

 
3rd Qtr

2017

9 Months

2017

Dow Jones Industrials index 5.6% 15.5%
S&P 500 index 4.5% 14.2%
NASDAQ 5.8% 20.7%
S&P 400 mid-cap index 2.8% 8.2%
Russell 2000 small-cap index 5.3% 9.9%
Total International, excluding US 5.9% 21.6%
Dow Jones Global Stock index 4.7% 15.5%
Barclays US Aggregate Bond index  0.7 % 3.1%

 

Economic and Market Outlook   Although economic growth remains sluggish, the US economy appears healthy and resilient.  The slow growth has often been attributed to the increase in government spending and regulation.   Interest rates remain low by historic standards and US unemployment is a low 4.4%.

Tax reform will be a key item on the Congressional agenda this year and a significant reduction of the corporate tax rate would make stocks more attractive. Yet the US is still running a significant budget deficit, even after eight years of economic expansion, which leaves very little wiggle room for true tax cuts.  Historically the country would be running a budget surplus at this stage of the economic cycle, but both the size of the government and government spending have grown at least as fast as the economy.  This leaves little room to cut taxes now and little “ammunition” to use during the next economic downturn.  Our elected representatives seem to have forgotten that “budget surplus” is not a four letter word.  Increasing the deficit by cutting taxes without reducing spending will compound the problem.  Perhaps a prudent and face saving way would be for Congress to cut tax rates while also eliminating deductions, leaving tax collections little changed.

The earnings of US S&P 500 companies are expected to grow about 6% to for calendar year 2017, which is also a reasonable estimate of their long term growth. Over the long term, financial theory predicts that unless the price-earnings ratio changes, stock prices will grow in line with the sum of the rate of  corporate profit growth  plus dividends (currently about 2%), or a total of about 8%.  Since the price-earnings ratio of US stocks is relatively high, it will be unlikely for US stock returns to continue at their current pace for much longer.

Foreign stock markets, especially emerging markets are now more attractively valued than the US, and should produce better returns over the intermediate term. Of course they are also subject to more political risk and currency risk than US stocks.

Most economists expect interest rates to continue to rise, which will reduce the value of existing bonds. This will impact long term bonds more than short term bonds.  If the increase is slow, as expected, it will present a mild headwind for fixed income investors and most bonds (and bond funds) should continue to produce positive returns as interest income more than offsets the loss in value.  A significant increase in interest rates would likely produce volatility in the stock and bond markets.

We remain cautiously optimistic for the remainder of 2017. Because of the many political uncertainties here and abroad, it would be prudent to invest cautiously and expect that higher returns will come from outside the US. 

The growing government debt burden     Governments are prone to make promises they can’t keep and spend more than they take in. Over time, these annual deficits have become sizable debts.  Sometimes this debt can be disguised or not shown on financial statements.  On a national level, this has occurred in our Social Security and Medicare commitments.  On a state and local level this occurs in pensions and healthcare benefits promised to government workers and retirees.  The extent of the problem varies from state to state and locale to locale.  Every year, the non-partisan Truth in Accounting organization rates the states and for 2016 rated CT, IL and NJ in the worst shape.  CT and IL have liabilities of approximately $50,000 per tax payer and NJ over $67,000 per tax payer.  Municipalities such as Detroit and Stockton CA have already gone through bankruptcy.  Hartford and other cities which have made generous promises to government workers may face the same prospect.  This will pit taxpayers against government employees and bond holders.   Property values will fall and bondholders, tax payers, government workers and retirees will suffer.  Human nature suggests that the government will avoid taking responsibility and instead point fingers at others, including those who held office before them. Bond holders, property owners, tax payers and employees in cities and states which have promised more than they can deliver may face a challenging future.

Disadvantages of Variable Annuities   Variable Annuities (VA’s) can be an extremely complicated contract between an investor and an insurance company.  Besides being overly complicated, they are often illiquid and an expensive way to invest. Another troublesome aspect is that although taxes on gains are deferred until funds are withdrawn from the VA, all gains are taxed as ordinary income, rather than capital gains.  And upon death, there is no “step-up in basis” as with a taxable account, so your heirs may face a needlessly high tax bill when they liquidate the VA.


Second Quarter 2017

July 7, 2017 / Quarterly Newsletters

Equity markets around the globe overcame geopolitical concerns and continued their upward trend.   As in the first quarter, international stocks, emerging markets, and US technology stocks led the way.  The S&P 500 index of large US stocks is now up 9.3% this year.   Turkey, Korea and European stocks were top performers in the recent quarter, and although US small companies lagged they still posted respectable returns.  International returns were strengthened as foreign currencies strengthened about 6% on average compared to the US dollar.

The Federal Reserve increased short term “federal funds” interest rates by 0.25% (to target a range of 1.0% to 1.25%) in June, the second increase this year and the third since 2015.  The rate increase indicates that the Fed believes the US is making progress toward its objectives of full employment and it wishes to avoid inflationary pressures.  In contrast to rising short term interest rates, the rate on ten year US Treasury bonds declined modestly from 2.4% at the beginning of the year to 2.3 %, but remains considerably higher than the 1.4% low last July. The recent decline in long term rates is somewhat perplexing since it may indicate that bond investors are not quite as optimistic about the prospects of economic growth as the Fed.  The Fed also announced it will begin reducing the $4 trillion in US Treasury and mortgage securities that they acquired during the financial crisis.  They will initially reduce bond holdings by $10 billion per month and gradually increase that to $50 billion per month.   If anything, this planned reversal of QE (quantitative easing) would be expected to increase long term rates, but that has not happened yet.

Bonds achieved modest returns with the US Aggregate Bond Index advancing 1.5% during the quarter and are now up 2.4% for six months.

Equity markets advanced in spite of several uncertainties and concerns including:

  • How fast and how high will the Federal Reserve raise interest rates?
  • How will Great Britain fare in its negotiations over terms to leave the European Union?
  • What impact will the “snap” election which undermined Prime Minister May have in the “Brexit”   negotiations?
  • How will the rising tension between the US and North Korea be resolved?
  • What are the chances for the US passing healthcare and tax legislation and if passed what form will they take?

Returns for key indexes were:

 
 

2nd Qtr

2017

 

1st Half

2017

Dow Jones Industrials index 3.9% 9.3%
S&P 500 index 3.1% 9.3%
NASDAQ 3.9% 14.1%
S&P 400 mid-cap index 1.6% 5.2%
Russell 2000 small-cap index 2.5% 4.8%
Total International, excluding US 5.7% 17.8%
Dow Jones Global Stock index 3.7% 10.3%
Barclays US Aggregate Bond index  1.6 % 2.4%

 

Economic and Market Outlook   The US economy appears healthy and resilient, although economic growth remains sluggish.  The US GDP grew a measly 1.4% in the first quarter, but is estimated to have grown at a 2.9% rate in the second quarter.   Interest rates remain low by historic standards and US unemployment is a low 4.3%.

There are many approaches to assessing stock market valuation. Some show the market to be undervalued while others show it to be overvalued.  One valuation metric, which uses interest rates and corporate earnings, suggests that the S&P 500 is currently 10%undrvalued.  A significant reduction of the corporate income tax rate would make stocks even more attractive.

The earnings of US S&P 500 companies are expected to grow 6.5% for calendar year 2017, which is in line with historic long term profit growth. If US equities are near their fair value, then long term equity returns should be in line with the growth of corporate profits plus dividends paid (currently about 2%).

Most economists expect interest rates to continue to rise, which will reduce the value of existing bonds. This will impact long term bonds more than short term bonds.  If the increase is slow, as expected, it will present a mild headwind for fixed income investors and most bonds (and bond funds) should continue to produce positive returns as interest income more than offsets the loss in value.  However a significant increase in interest rates would likely produce volatility in the stock and bond markets.

Foreign markets have lagged the US for the last six years however both emerging markets and developed markets are now more attractively valued than the US. At this time it does not appear that the US is preparing to significantly increase tariffs which would materially affect foreign markets.

We remain cautiously optimistic for the remainder of 2017. Because of the many political uncertainties here and abroad, it would be prudent to invest cautiously and expect that higher returns will come from outside the US.

Preparing for a market downturn           The US stock and bond markets have been remarkably and uncharacteristically calm in recent years.  Historically, the S&P 500 index suffers a 10% decline once every 12 to 18 months and a 20% “correction” every three years. Yet we need to look back to 2015 when the S&P 500 dropped (temporarily) slightly more than 10% and back to 2011 when it declined 18%.  It typically takes the market four months to recover after a correction, but this can vary greatly.  It is important for investors to be prepared for a market decline at any point in time.  While we are not forecasting one in the near future, it certainly will occur at some point.  When it does, it is important for investors to have realistic expectations and not do anything rash.  Studies have shown that one of the most important things an investor can do is to control their behavior during market downturns. Panicking and selling after a decline can significantly undermine long term returns.  It is helpful to resolve not to do that before a decline occurs since when the markets are dropping it is too easy to let emotions rule.

While market volatility can be uncomfortable, it can also be an opportunity. A market recovery will likely begin at the point of maximum pessimism and the strongest market advances will likely occur early in the recovery.  If investors anticipate the market advances and participate in them and not be influenced by the then prevailing bad news in the media, they will have a decided advantage.

Backdoor Roth IRA    Both traditional IRA’s and Roth IRA’s are subject to contribution limitations based upon taxpayer earnings. However, there are no earning limitations for contributions to non-deductible IRA’s.  And there are no earnings limitations on conversions of non-deductible IRAs to Roth IRA’s.  This opens a “backdoor” opportunity for taxpayers whose earnings are too high for a direct contribution to a Roth IRA to first make a contribution to a non-deductible IRA and then convert this to a Roth (after waiting a respectable period of time).  If the taxpayer has no other traditional IRA’s the only tax that would be due is from any gain on investments in the non-deductible IRA before it is converted to a Roth.   This is something that can be done every year and over time an investor can build up a reasonable sized Roth IRA which will never be taxed.  One caveat is that if the taxpayer has traditional pre-tax IRAs, then IRS “pro-rata” rule limits will result in taxes on the conversion.  However, if the taxpayer’s 401K plan allows, it may be possible to move traditional IRA’s to their 401K plan and then contributing to a non-deductible IRA and converting it to a Roth.


First Quarter 2017

April 6, 2017 / Quarterly Newsletters

Global equity markets advanced strongly in the first quarter, overcoming geopolitical concerns in the US and abroad.  In contrast to last year, foreign markets, especially emerging markets, and technology stocks in the NASDAQ  led the way while US small caps saw more modest returns.   Top-performing markets included Brazil, India, Mexico and Chile.  Although the US Standard and Poors 500 index turned in a strong performance, most emerging markets along with developed markets in Europe and Japan performed even better.

The Federal Reserve raised short term interest rates by 0.25% in March, the second increase since December 2015, and an indication that the Fed believes the US economy is making progress toward its objectives of full employment and price stability. The rate on ten year US Treasury bonds remained virtually unchanged from the beginning of the year at 2.4%.  Bonds achieved modest returns with the US Aggregate Bond Index advancing 0.8%.

Equity markets virtually ignored the political and legislative controversies in Washington, the Federal Reserve’s move to raise interest rates, the decision by Great Britain to move forward with their exit from the European Union, and the upcoming elections in Italy and France which could also impact the stability of the European Union. An old Wall Street saying “bull markets climb a wall of worry” rang true this quarter.

Returns for key indexes were:

 
Full Year

2016

1st Quarter

2017

Dow Jones Industrials index 16.5% 5.2%
S&P 500 index 11.9% 6.1%
NASDAQ  7.5% 9.8%
S&P 400 mid-cap index 18.7% 3.6%
Russell 2000 small-cap index 19.5% 2.1%
Total International, excluding US   4.8% 8.6%
Dow Jones Global Stock index    5.9% 6.4%
Barclays US Aggregate Bond index    2.4% 0.8%

 

Economic and Market Outlook   The US economy is healthy and resilient, although economic growth remains sluggish.  Interest rates remain low by historic standards and corporate earnings are expected to post strong growth for the first quarter.  Unemployment is a low 4.7%, but this low rate may be partly attributable to a steady erosion of individuals choosing to participate in the work force over the last half-century.

Although the economy is healthy, there is a good deal of political, economic and market uncertainty surrounding the new President and Congress. The Trump administration said they will initiate corporate tax reform and streamline burdensome regulations both of which should prove beneficial to corporate earnings and a likely reason that US equity markets have rallied since the election.   As we learned from the recent attempt to pass new healthcare legislation, the legislative process is often difficult to predict and impossible to know what, if any, new tax legislation may result.  This creates a good deal of uncertainty in forecasting after-tax corporate earnings and a fair value for stocks.

While some policies proposed in the presidential campaign, such as tax and regulatory reform, if passed, should prove positive for the markets, others, such as tariffs or trade barriers, could undermine the earnings of US and foreign corporations. Some proposals, such as the border adjustment tax (BAT) may sound good on the surface, but are complex and a dramatic change from our existing system that could result in unintended and undesirable consequences.

Adding to that uncertainty, the Federal Reserve is expected to increase interest rates two more times this year and begin reversing Quantitative Easing (QE) by not purchasing new bonds as their current holdings mature. Small and infrequent rate increases would likely have minimal impact on the financial markets however large and more frequent rate hikes would create a serious obstacle to both the stock and bond markets.  Since QE has not been tried before, no one knows for certain what the impact of reversing it will be.

The US equity market represents slightly more than half of global equity markets (as measured by market value). Historically, a globally diversified equity portfolio has performed better than a strictly US portfolio more often than not.  That was not the case the last six calendar years as the US outshone most foreign markets.  As a result of the stronger performance in the US market in recent years, both developed and emerging overseas markets are more attractively valued compared to the US.

Foreign markets also face uncertainty, particularly in the European Union as Great Britain negotiates their exit and Italy, Germany and France face elections which could influence their status within the EU.   We have learned that elections are sometimes difficult to predict and these are the three largest economies in the Euro Union that have zone adopted the Euro as their currency, so it is important to keep these risks in mind.

Emerging markets are also significantly undervalued compared to the US, however their corporate earnings could be adversely affected by a strengthening US dollar, rising interest rates, and potential US trade tariffs.

Slowly rising interest rates may present a mild headwind for fixed income investors since they diminish the value of existing bonds. Shorter term bonds will not be subject to as much interest rate risk as longer term bonds.  If interest rates rise slowly, as is expected, most bonds and bond funds should continue to produce positive returns.

Because of the many political uncertainties here and abroad, it would appear to be prudent to invest cautiously both in the US and overseas.

To improve the US economy, which has been growing at a sluggish 2% per year we may need to set aside the “easy answers” politicians have proposed.   Instead we need to focus on increasing the size of the workforce and making them more productive.  To increase the size of the workforce we need to either increase the proportion of our population in the workforce (which has been declining for decades),  and / or increase the number of qualified immigrants. Embracing technology such as robotics, while training (or re-training) displaced or under-employed workers (along with those no longer seeking employment) would appear to offer opportunities to ramp up US economic activity while also reducing national strife.  While easier said than done, adopting a national focus on this is critical for our economic strength, ability to finance future government spending on defense, social programs and entitlements, as well as our national cohesion.

The growing prominence and cost of Medicaid    Medicaid was created without much fanfare in 1965 as a small program to cover poor people’s medical bills. Over the following fifty years its mission has expanded to include people with incomes up to 133% of the poverty level falling into certain categories including low-income parents and children, pregnant women, low-income seniors, and adults without dependent children  Originally the federal government shared the costs with the states and  each state established their own rules.  The Affordable Care Act (“Obamacare”) expanded coverage with the federal government now paying up to the entire costs for certain newly eligible beneficiaries.  Critics suggest that this now gives the states less incentive to control costs.  According to the NY Times, Medicaid has surpassed Medicare in the number of Americans it covers.  Medicaid now insures 20% of the US population, 40% of American children, 50% of all births and 66% of people in nursing homes.  (Yet, according to the New England Journal of Medicine there is no significant difference in mortality, blood pressure or diabetes of Medicaid recipients vs the uninsured.)   Due to the large number of people receiving Medicaid (and who want to continue to receive it) and high costs associated with it, it has become a very important element in our national discussion on healthcare.


Fourth Quarter 2016

January 5, 2017 / Quarterly Newsletters

In the hours immediately following the US Presidential election, global equity markets declined briefly before advancing strongly in November and early December. Although the advances plateaued after the Federal Reserve raised interest rates in December, US equity markets posted strong returns for the fourth quarter, capping a respectable year. Most US stock market indexes posted double digit returns for 2016, the best year since 2013.  The Dow Jones Industrial Average has more than tripled since March 9, 2009, at the depths of the financial crisis and the S&P 500 has gained even more.  Small company US stocks lead the way in 2016 while most major foreign markets lagged significantly.

Financial markets withstood a myriad of concerns in 2016, including declining oil prices, a slowing Chinese economy, the possibility of rising interest rates, the British vote to exit the Eurozone, the resignation of the Italian Prime Minister Matteo Renzi, and the unexpected election of Donald Trump.   It is generally considered a bullish sign when markets advance in the face of what many investors consider bad news.

The Federal Reserve raised short term interest rates by 0.25% in December. This was the first increase since December 2015, and an indication that the Fed believes the US economy is making progress toward its objectives of full employment and price stability.  Short term rates are still very low by historic standards and the Fed appears ready to raise rates two or three times in 2017.

The interest rate on ten-year US Treasury bonds declined from 2.27% at the beginning of the year to 1.49% in June and has since the election has risen abruptly to 2.45%. Rising interest rates provided a head-wind for bond returns and the US Aggregate Bond Index lost 3.1% for the quarter but closed up 2.4% for the year.

The prospect of stimulative spending by the Trump administration and interest rate increases by the Fed made the US dollar more attractive vs. foreign currencies. The US dollar has risen 5% on a trade-weighted basis since the election and is now up 4% for the year.  The strong US dollar resulted in lower dollar returns on overseas investments.

Returns for key indexes were:

 
1st Nine

Months

2016

 

4th Qtr

2016

 

Full Year

2016

Dow Jones Industrials index 7.2% 8.7% 16.5%
S&P 500 index 7.8% 3.8% 11.9%
NASDAQ 6.1% 1.3%  7.5%
S&P 400 mid-cap index 11.0% 7.0% 18.7%
Russell 2000 small-cap index 10.2% 8.4% 19.5%
Total International, excluding US 6.9% 2.0%   4.8%
Dow Jones Global Stock index 5.1% 0.8%      5.9%
Barclays US Aggregate Bond index 5.7% 3.1%    2.4%

 

Economic and Market Outlook The US economy is healthy and resilient as we enter 2017.  Although economic growth is sluggish, unemployment has declined to 4.6%, and interest rates remain low by historic standards. The Trump presidential administration will likely initiate corporate tax reform and streamline burdensome regulations both of which should prove beneficial to corporate earnings and are the likely reasons that US equity markets have rallied since the election.

There are several methods of measuring whether the stock market is over or under-valued and at this juncture there is no consensus. Some methodologies suggest that the US market is overvalued while others suggest it is undervalued.

Financial markets will face new and unknown policies in a Trump administration. Some policies, such as tax and regulatory reform, should prove positive for the markets, while others, such as tariffs or trade barriers, could undermine the earnings of US and foreign corporations and be a negative for businesses, the economy and markets.   An additional uncertainty is that the Federal Reserve is expected to increase interest rates three times in the coming year.  Small and infrequent rate increases would likely have minimal impact on the financial markets however large and more frequent rate hikes would create a serious obstacle to both the stock and bond markets.

Although both developed and emerging overseas markets are undervalued, foreign markets face challenges in the upcoming year. The European Union is contending with the aftermath of Britain’s vote to exit the European Union and additional potential challenges lie ahead.  If there were any lesson to be learned from 2016 it was that voters around the globe are dissatisfied with their current elected representatives and sometimes elections produce unexpected results.  With that backdrop, it is with some trepidation that Germany, France and Italy, the three largest economies in the Euro Union and which have zone adopted the Euro as their currency, face elections in 2017.  Some geopolitical analysts believe that the European Union is in a slow process of unravelling. If election results in any of the three countries indicate the slightest hint that any of the winning candidates even question whether they should continue their membership in the EU, it could conceivably generate significant market volatility.

Emerging markets are also undervalued by historic measurements. Because much of the corporate debt in emerging markets is denominated in dollars (rather than local currency), rising interest rates combined with a strong dollar make it more expensive for companies in emerging markets to pay interest on their loans, creating an obstacle to earnings growth.

Rising interest rates also present a challenge to fixed income investors since they diminish the value of existing bonds. Shorter term bonds will not be subject to as much interest rate risk as longer term bonds.  If interest rates rise slowly, most bonds and bond funds should continue to produce positive returns, although they will be fighting a headwind

While there are many reasons to be optimistic as we enter the New Year, the many political uncertainties here and abroad, suggest it would be prudent to invest cautiously both in the US and overseas.

The impact of rising government debt when interest rates are also rising.   It is no secret that the US faces serious long term fiscal challenges.  The US national debt held by the public is currently about 77% of GDP, the highest ratio since 1950, during the Korean War and in the aftermath of World War II.  During fiscal year 2016, the budget deficit was nearly $600 billion, which means about $1.6 billion per day was added to our national debt.  According to the non-partisan Congressional Budget Office (CBO) the debt will exceed $1.2 trillion in ten years unless spending is reduced and/ or taxes increased.  The growth in the deficit is due to the significant increase in spending on retirement and healthcare (as a result of aging baby boomers) along with the growing interest payments on the debt.  If tax and / or spending policies are not changed, within eleven years interest costs are expected to be the third largest category in the federal budget, just behind Social Security and Medicare. In slightly more than thirty years, interest payments will be the largest category of government spending, and more than double what the government spends on R&D, infrastructure and education combined and will crowd out spending on social programs, education and defense.  The current situation is the result of the spending policies of both political parties, both houses of Congress and spans multiple Presidential administrations. Doing nothing is not a viable option if we believe that we have a responsibility to future generations and the future of the country


Third Quarter 2016

October 4, 2016 / Quarterly Newsletters

In the aftermath of the June “Brexit” vote, global equity markets briefly declined before advancing for the quarter. Most major stock market indexes are now ahead for 2016 with emerging markets and US small companies leading the way. Volatility appears to be increasing as we grow closer to the US presidential election and the possibility of a Federal Reserve interest rate hike.

This year the financial markets have withstood a myriad of concerns, including declining oil prices, a slowing Chinese economy, the possibility of rising interest rates, and the British vote to exit the Eurozone. In spite of this “wall of worry” equity markets have advanced, which is often considered characteristic of a bull market.

The interest rate on ten-year US Treasury bonds declined from 2.27% at the beginning of the year to 1.49% in June and has since risen slightly to 1.6%. Rising interest rates provided a head-wind for bond returns and the US Aggregate Bond Index advanced only 0.4% for the quarter.

Returns for key indexes were:

 
 

1st Half

2016

 

3rd Quarter

2016

 

9 Months

2016

Dow Jones Industrials index 4.3% 2.8% 7.2%
S&P 500 index 3.8% 3.9% 7.8%
NASDAQ 3.3% 9.7% 6.1%
S&P 400 mid-cap index 7.0% 3.7% 11.0%
Russell 2000 small-cap index 1.4% 8.7% 10.2%
Total International, excluding US 0.1% 6.8% 6.9%
Dow Jones Global Stock index 0.1% 5.0% 5.1%
Barclays US Aggregate Bond index 5.3% 0.4% 5.7%

 

Economic and Market Outlook The US election is prominently in the news and although financial markets do not like uncertainty, so far they have remained comparatively stable. As election day grows near, and polls indicate it will be a close election, we may see an increase in volatility, however that may be short lived.

There does not seem to be any clear relationship between a presidential election and future stock returns. Historically when the market was up in the three month preceding the election, the odds greatly favored the incumbent party.  Yet with only one month to go before the election, the stock market has been flat for the past two months so the financial markets are not providing an indication on the outcome of this election.

Profits of US corporations have declined over the last five quarters due to declining oil prices and a strengthening US dollar, resulting in lower profit’s (in dollars) earned abroad. Although those two trends have stabilized or reversed, it appears that earnings of US corporations will be lower again for the third quarter.  It will be difficult for stocks to advance without a more positive outlook for corporate profits.

Although the Federal Reserve is likely to raise interest rates by December, that should not be a source of concern. Interest rates have been held at historically and artificially low levels and slightly higher rates will not have a significant impact on economic growth.  Higher rates should be viewed as the Fed’s belief that the economy is on the right track and can withstand higher rates.

The US economy continues to inch ahead. Employment and consumer spending are up, home and auto sales remain strong and economic growth is estimated to be 2% in the second quarter.

Foreign stocks of Europe, Japan and emerging markets are all more attractively priced than US stocks, but as the Brexit vote indicated, there is significant uncertainty and discontent in Europe. Italy, (which does not have its own currency like England) will have an important referendum in December which could conceivably result in steps to exit the European Union (EU).    Other European countries are also evaluating what their relationship should be with the EU.  As a result of the 2008 financial crisis, rising income disparities, and the refugee crisis, the cohesion of the EU and its benefits are being questioned.  It would only take one member of the Eurozone common currency (EZ), such as Italy, to secede from the EU to cause it to begin to unravel with significant financial and geopolitical consequences.  It would be prudent to remain cautious in investing overseas considering the potential for disruption.

With core inflation running at 2.3% there is little financial incentive for long term investors to invest in CD’s or money market funds which are paying negligible interest and savers are losing purchasing power every day.

Politics and Investing  It is important to differentiate politics from investing.  While the US election may raise emotions, the next President will need approval from Congress for new legislation.  Innovations by individuals and corporations create value for investors, not politicians.  The President will have little impact on the ability of individuals and companies to innovate and produce new pharmaceuticals, the next iPhone, or more efficient means of producing energy, etc.   Don’t let politics distract you from the important elements of investing.

Government Spending    Both US presidential candidates have promised to increase government spending at a time when the US budget deficit and level of debt is already projected to grow to alarmingly high levels.  This is due to an aging population, rising healthcare costs and Social Security benefits.  Continued or increased government deficit spending will increase US interest payments and result in either significant tax increases or a reduction in spending on other government programs. While it may take some time for the “chickens to come home to roost”, the US is already heading in the wrong fiscal direction.  If Congress fails to exercise fiscal restraint and a new administration throws “fuel on the fire” by increasing spending, it would not be good for economic growth, the stock market or future generations of Americans.  Some campaign promises are best left unfulfilled.

Economic Statistics    Whenever we hear economic statistics it is natural to consider GDP a highly accurate measure. In reality, GDP is a complex concept, not a specific item that can easily be measured.  The methodology has been derived from multiple subjective decisions made by the government and economists over a long period of time.  Initially GDP began as a measure of private industrial production such as cotton and steel to measure readiness for war. Military and government expenditures were excluded since they were not considered “productive”.  The government then desired to include these expenditures in order to show economic growth even in war.  Later expenditures for services were added to reflect the growing importance of that sector of the economy.   Then adjustments were made to reflect improving characteristics of items like computers, TV’s and autos.  Inflation is now also taken into consideration to determine the “real” gains.  Since there are many ways to calculate inflation, that adds another subjective element.  For international comparison, exchange rates must be used, but since exchange rates fluctuate, there needs to be a determination of what exchange rate to use. The result of the current rules can be quite interesting and are inherently political.  If you pay someone wages to mow your lawn or clean your house that increases GDP unless you pay them under the table or you or your spouse does it.   Not long ago the Greeks pressed criminal charges against a highly respected economist responsible for accurately reporting statistics (i.e. for not cooking the books) and the UK economy gained 5% once prostitution and illegal drug sales were included.  In 2013 the US GDP increased by 3% when it added  art, music, film royalties, books, theater and R&D spending, the first country to include these.  Wages paid to school teachers and bankers are included in the GDP, but determining their productivity is nearly impossible. Reportedly there may be only a dozen experts in the world who truly understand GDP.  It is prudent to be cautious about treating GDP numbers as a precise measurement.


Second Quarter 2016

July 7, 2016 / Quarterly Newsletters

The US stock market advanced modestly in the first half of 2016 but was subject to shifting tides and an unanticipated result of a British referendum to leave the Eurozone.  The year began with a 7.5% decline in the S&P 500 over fears of declining oil prices, a slowing Chinese economy and concern that interest rates would rise.  Instead, interest rates declined, oil prices stabilized and the stock market advanced slowly but steadily until late June when investors shifted their attention from Asia and toward Europe as the British voted to secede from the European Union.  In the aftermath of the “Brexit” vote, the US stock market declined 5% in a few days but rebounded just as quickly and the S&P 500 ended the first six months with a modest gain.

The European and Japanese stock markets lost ground while Canada, Australia, and emerging markets, especially Brazil, advanced in the first half year. However, taken as a whole, a size weighted composite index of all the foreign markets ended the first half of the year not far from where it began.

After many years of declining and stagnating, gold, precious metals and commodities advanced strongly.

Six months ago most economists thought interest rates would move higher. However slow economic growth, and moves by many central banks to provide liquidity to avert potential market volatility resulting from the British vote helped push the yield of the ten year US Treasury bond down.  The rate declined from 2.27% at the beginning of the year to 1.78% in March and to a record low 1.385% after the Brexit vote, to close June at 1.49%.  Falling long term interest rates boosted the prices of bonds, and resulted in a strong return for the Barclays US Aggregate Bond Index of 5.3%, more than most stock indexes.

As low as US interest may seem, the central banks of Japan, Sweden, Switzerland and Denmark all have a policy of zero or negative interest rates.

Returns for key indexes (including dividends) were:

 
1st Qtr

2016

2nd Qtr

2016

1st Half

2016

Dow Jones Industrials index 2.2% 2.1% 4.3%
S&P 500 index 1.4% 2.5% 3.8%
NASDAQ 2.8% 0.6% 3.3%
S&P 400 mid-cap index 3.3% 3.5% 7.0%
Russell 2000 small-cap index 1.9% 3.4% 1.4%
Total International, excluding US 0.1% 0.3% 0.1%
Dow Jones Global Stock index 0.2% 0.3% 0.1%
Barclays US Aggregate Bond index 3.0% 2.2% 5.3%

 

Economic and Market Outlook

The British vote to leave the EU has created a good deal of geopolitical uncertainty and has raised many questions. The close vote highlights the divisions within Britain about whether to remain in the EU and serves as a wake-up call that the EU itself will need to make significant changes in order to survive in its current form. Although changes will be forthcoming, no one knows what they ultimately will be.  I am cautiously optimistic that changes will be positive and result in the EU removing burdensome regulations and Britain remaining part of the EU. The media may highlight other, less attractive, less probable outcomes, but investors should not allow media hype to sway their investment decisions.

To help offset negative economic consequences of the Brexit vote and provide a positive boost to the global financial markets the European Central Bank may reduce interest rates and the US Federal Reserve may delay rate increases.

The US economy continues to inch ahead. Employment and consumer spending are up, home and auto sales remain strong and economic growth is estimated to be 2% in the second quarter.  Corporate earnings are growing in the US again, especially among energy companies.  Higher earnings should provide a catalyst for advances in the stock market.  Professor Jeremy Siegel of the University of Pennsylvania says that if rising oil prices produce a rebound in the earnings of energy companies and corporate earnings grow in the second half, that the stock market could rise 10 to 15 percent in the second half of 2016.

Foreign stocks of Europe, Japan and emerging markets are all more attractively priced than US stocks, but as the Brexit vote indicated, there is significant uncertainty in Europe. That vote highlighted the uncertainty of the future of the European Union so it would be prudent to remain cautious in investing overseas.

With core inflation running at 2.3% there is little financial incentive for long term investors to invest in CD’s or money market funds which are paying negligible interest and savers are losing purchasing power every day.

Politics and Investing  It is important to differentiate politics from investing.  While the US election may raise emotions, the next President will need approval from Congress for new legislation.  Innovations by individuals and corporations create value for investors, not politicians.  The President will have little impact on the ability of individuals and companies to innovate and produce new pharmaceuticals, the next iPhone, or more efficient means of producing energy, etc.   Don’t let politics distract you from the important elements of investing.

Don’t be like the musician Prince who died without a will.  His estimated $300 to $800 million estate will now be distributed in accordance with the laws of the State of Minnesota where he lived.  He will not have the chance to take steps to minimize the massive estate taxes nor gift to charities or individuals he cared for.  Further, the process will be played out in public, rather than privately as it would if he had a revocable living trust.

Behavior Gap   Many studies have shown that on average, returns investors achieve are significantly lower than their investments. How is that possible?  The answer is that investors often buy high and sell low, exactly the opposite of what they should do.  When the stock market goes down, investors over react to bad news by selling rather than buying.  The final result is investor behavior, not investment returns that govern the results that most investors achieve.

Tariff’s    Periodically voices arise denouncing free trade and declaring that protectionist import tariffs would solve many problems. This is in direct contradiction to virtually all economic theory which suggests that nations prosper most when free trade exists between all countries so each nation can put their manpower and resources to their best use.   The adoption of the Smoot-Hawley tariff in 1931 has been often cited as one of the causes of the great depression.  It precipitated a cycle of one country after another adopting tariffs.  Today, most countries still have some tariffs to protect local businesses, but it costs consumers a significant amount in higher prices.  Current tariffs in the US include auto tires, paper clips, sneakers, canned tuna, and synthetic fabrics.  While ostensibly these taxes are paid by the seller, the reality is that they directly increase the price consumers pay.

 

John W. Eckel CFP®, CFA


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