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Second Quarter 2014 - Pinnacle Investment Management, Inc.

Second Quarter 2014

July 3, 2014 / Quarterly Newsletters

July 2014

Global markets advanced with low volatility during the second quarter After a tepid first quarter, equities advanced at a more respectable rate and are now on pace to produce low double-digit returns for the year. Most foreign stock indexes kept step with the US market and emerging markets did even better. Commodities, REITs (real estate investment trusts) precious metals and natural resources also had strong returns but the Japanese and German stock markets lagged most other countries.

Although forecasts suggested that interest rates would rise, the yield on the ten year US Treasury bond declined from 3.1% at the beginning of the year to 2.6% in June. Declining rates boosted bond prices and the broad US bond market is now on pace to produce mid single-digit returns for the year.

Declining bond yields generally reflect a belief that the economy is cooling, while rising stock prices generally reflect the opposite view, so the two markets are sending conflicting signals. Rising commodity and precious metals prices also usually reflect a strengthening economy and rising inflationary expectations, which also conflicts with the bond market. The disconnect between the bond market and the stock and commodity markets may be due to efforts by the Federal Reserve, the European Central Bank (ECB) and the Bank of Japan to keep interest rates low.

The Federal Reserve, which had been purchasing $85 billion of bonds each month in response to the financial crisis, began to reduce (taper) their purchases in January by $10 billion per month and are expected to stop their purchases by the end of the year.  Fed Chair Janet Yellen has indicated that, given current economic forecasts, she expects that the Fed will begin to raise short term interest rates six months after that but some economists believe the Fed may wait for the US economy to improve further before raising rates.

Returns for key indexes (including dividends) were:

1st Qtr
2014
2nd Qtr
2014
1st Six Mos.
2014
Dow Jones Industrials 0.2% 2.8% 2.6%
S&P 500 1.8% 5.2% 7.1%
NASDAQ 0.5% 5.0% 5.5%
S&P 400 mid-cap 2.7% 3.9% 6.7%
Russell 2000 small-cap 0.8% 1.7% 2.5%
Total International, excluding US 0.4% 5.2% 5.6%
Dow Jones World Stock 0.8% 4.4% 5.2%
Barclays Aggregate Bond Index 1.8% 1.9% 3.8%

 

Economic and Market Outlook   Except for the first quarter of 2014 in which adverse weather had a dominant influence, the US economy continues to grow, albeit at a relatively slow rate. Corporate earnings are fairing better and it is expected that earnings of S&P 500 companies will grow at double digit rates for the year.

Most analysts believe that the US stock market is fairly valued relative to historic valuations and the level of interest rates. Although Professor Jeremy Siegel of the University of Pennsylvania believes the US stock market is 10% undervalued, other analysts are more cautious.    After the strong performance of the US stock market last year, it is reasonable to expect more moderate stock market returns.

Foreign stocks, especially emerging markets, now appear to be more attractively valued than the US. While the European financial crisis has not been fully resolved, and significant issues still need to be addressed, investor confidence is returning and the possibility of a major crisis occurring has become more remote. The central banks of Europe (and also Japan) are striving to boost their economies by keeping interest rates low. As a result, it seems an appropriate time to increase emphasis on foreign stocks.

As a consequence of quantitative easing (QE) the Federal Reserve now owns $4 trillion of bonds and other financial assets, six times what they held in 2007. The Fed purchased most of the bonds from banks and until recently the banks have let most of the proceeds sit as “excess reserves” rather than lend them. It now appears banks have recently increased their lending, which should boost the economy. It will also increase the monetary supply that in turn will increase inflationary pressures.  It appears the Fed has no plans to sell their bond holdings, but rather will wait until they mature, which may provide further opportunity for the monetary supply to grow and spur inflation.

The Federal Reserve now suggests that they will hold short term interest rates low for longer than previously believed. While this may help the economy, it will likely add additional inflationary pressure. An increase in inflation eventually results in higher long term interest rates and higher values for commodities, precious metals, real estate and other real assets. Inflationary pressure has not been an issue for years, but now seems more likely.

It should be noted that inflation is not assured. The European Central Bank (ECB) has been concerned with avoiding deflation, and with inflation running under 1% for the last nine months the ECB considers Europe to be in an a deflation “danger zone”. Deflation can be an even greater problem than inflation and the ECB is striving to increase inflation to above 1%, so far without success. Although unlikely, it is possible that the US could find itself in a similar situation.

The world is not without risks and at the moment the major risks appear to be Middle East geopolitics. While a major military confrontation or interruption of oil supplies seems remote, it could impact the global economy and create volatility in the global financial markets.

The factors mentioned above suggest an environment more favorable to stocks, commodities and precious metals than to bonds. They also suggest that due to the valuation level in the equity markets and the possibility, albeit remote, of geopolitical risk, that it is appropriate to be cautious.

 

Handling a stock market correction 

Historically, on average, we have had a 10% or greater stock market correction once a year but last experienced one about three years ago. Every three or four years on average we experience a 20% drop. Since neither we, nor anyone else, can predict the future, it does not make sense to sell in anticipation of a correction. And it never makes economic sense sell after a correction. Instead, if we experience a stock market decline, investors should focus on the long run, and remember that it is rare for all investments in a diversified portfolio to move totally in synch with each other.

 

Taxes do affect economic growth

Studies by the Tax Foundation and Truth in Accounting organizations show that states that have high debt and taxes per tax payer suffer a net migration of residents moving to states with low debt and taxes per tax payer. As hard as they may try, neither states nor the Federal Government have found a way to spend and tax their way to prosperity.

 

On average college graduates will earn $800,000 more than high school graduates according to a study by the Federal Reserve Bank of San Francisco. While college is expensive (arguably too expensive) it is still a sound intellectual and financial investment.


About the author

Pinnacle Investment Management: Pinnacle Investment Management, Inc. is a comprehensive investment management and financial planning firm committed to the financial future of our clients.


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