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Second Quarter 2016 - Pinnacle Investment Management, Inc.

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


About the author

John Eckel: CFP®, CFA is President of Pinnacle Investment Management Inc. of Simsbury. He has been included in BusinessWeek.com’s list of the Most Experienced Independent Financial Advisors, has been named four times to Worth Magazine’s list of Top Financial Advisors, included twice in Medical Economics list of Top Financial Advisors for Doctors and named twice in JK Lasers list of Top Professional Advisors for Baby Boomers.


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