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Third Quarter 2014 - Pinnacle Investment Management, Inc.

Third Quarter 2014

October 6, 2014 / Quarterly Newsletters

US large company stock indexes achieved small gains this quarter while smaller companies and international stocks struggled. The S&P and Dow Jones advanced and the S&P 500 is now up 8.3% this year. In contrast small and mid-size companies, along with international stock indexes, declined during the quarter. Those numbers do not tell the full story. The S&P is a “size weighted” index, with large companies such as Microsoft and Berkshire Hathaway weighted much more than smaller companies, so it does not reflect that fewer stocks have been participating in market advances. There have been recent divergences in other indexes as well. The Dow Jones is a price-weighted index and according to Barron’s, only four high priced stocks (United Health, Merck, Disney and Johnson & Johnson) accounted for 90% of the 2014 gain. Also, analysts have reported that 47% of the companies on the NASDAQ exchange and 20% of the Russell 2000 small cap companies are down at least 20% from their highs.

Concerns about conflicts in the Middle East, the Ukraine and the Ebola outbreak have contributed to an increased volatility in the financial markets and a downturn in September that affected all global markets.

Returns for key indexes (including dividends) were:

3rd Qtr
2014
Nine Months
2014
Dow Jones Industrials 1.9% 4.6%
S&P 500 1.1% 8.3%
NASDAQ 1.9% 7.6%
S&P 400 mid-cap 4.3% 2.1%
Russell 2000 small-cap 7.6% 5.3%
Total International, excluding US 5.6% 0.3%
Dow Jones World Stock 3.1% 2.0%
Barclays Aggregate Bond Index 0.3% 4.0%

 

Long term US interest rates are beginning to firm and short term rates have begun to rise modestly as the economy grows and the Federal Reserve ends its bond buying (“quantitative easing”). In contrast European and Japanese rates have declined as their economies struggle, and their central banks continue to buy bonds to hold rates low.

Ten year US Treasuries ended the quarter yielding 2.5% and two year Treasuries yielded 0.6%. In comparison, ten year German government bonds are yielding about 1% and Japanese bonds only 0.5%. The yields on two year German bonds have been zero and at times negative during the quarter. The higher US interest rates are helping advance the value of the US dollar relative to other currencies.

Economic and Market Outlook In spite of increased government regulations the US economy continues to grow, albeit at an erratic rate. New technologies, a recovery in homebuilding, increased energy production and a resurgence of manufacturing continue to move the economy forward and make the US a bright spot in the global economy.

For several years the US stock market has been advancing relatively steadily. It’s been three years since the market corrected 10% or more (it declined 19% in 2011). This is a relatively long run, but not the longest on record. The longest run without a 10% correction was nearly eight years from 1990-98 while the second longest was 4.7 years (2003-7). One of the paradoxes of the stock market is that the longer trends persist, the higher the probability is that it will continue, which provides a reason for optimism in spite of some recent market turbulence.

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 market last year, it is reasonable to expect more moderate stock market returns.

Foreign stocks, especially emerging markets, appear to be more attractively valued than the US, however a strengthening US dollar is working against foreign investments since they become worth less in US dollars as the dollar strengthens. If the dollar continues to strengthen materially, it will lead to foreign stocks becoming even more attractively valued.

The Federal Reserve may hold short term interest rates low for longer than previously believed. However at some point they will allow rates to rise. Rising rates are indicative of an improving economy and not necessarily a problem when rising from very low levels. According to S&P, on average the S&P 500 has historically risen 2.6% in the first six months following the first Fed rate hike, and 6.2% in the first twelve months. While that return is below average, it does provide a reason to remain invested.

Some sectors of the US market have been exhibiting significant strength, while others have been weak. Although large caps, biotech, pharmaceuticals, and technology have all done well, adding investments to these sectors after they have done well entails risk since they are now more highly priced. There have been other times in history, such as the late 1990’s, when the leading market sectors stumbled and were passed by sectors which had been lagging. The tortoise and hare parable also has relevance in the investment area. Mathematically over time, consistent returns will build more wealth than spectacular returns intermixed with poor returns.

Mid-term US elections are just around the corner, but they will not likely carry any significant impact for investors. Although it appears that the leadership in the Senate will change hands, that is not expected to alter the gridlock in Washington. It will be left to the next presidential administration to attempt to resolve the budget deficit and ungainly tax code.

The factors mentioned above suggest an environment more favorable to stocks, 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.

Questioning the Value of Hedge Funds Calpers, the second largest US pension fund announced that they will no longer invest in hedge funds since the returns have not justified their costs.

The Highway Trust Fund and questionable economics Taxes on gasoline pay for maintenance and improvements of the interstate highway system. However as a result of improved fuel efficiency, reduction in driving and inflation, the highway trust fund is operating at a substantial deficit. Rather than directly address the issue, Congress “solved” the problem by creative accounting. They reduced the amount that companies need to pay into underfunded pensions, thereby increasing their taxes. The additional taxes are expected to help fund the deficit. Congress has not addressed what will happen to the underfunded pensions or to what will eventually happen to tax revenues when companies offset underpayment today with payments in the future.

What is a Corporate Inversion?  An inversion (such as Burger King and Tim Hortons) typically involves a US company merging with a smaller overseas company and moving their headquarters overseas and the parent company ceasing to be a US taxpayer. It is called an inversion since the smaller company becomes the new parent. According to US tax code, the merger partner must be at least one-quarter its size. This does not mean that the company will avoid all US taxes since it must still pay taxes on all profits generated by its US locations. However, it does enable the company to avoid the high 35% US tax rate on profits generated overseas returned to the parent company. Corporate inversions are a sign of a problematic US tax code that provides the wrong incentives to companies who wish to operate in the best interest of their shareholders.


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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