MARKET COMMENTARY August 5, 2015
Dow Jones Industrial Avg. 17, 619.51 Standard and Poor’s 500 2063.11
2015(YTD) – 1.14 % 2nd Qtr. – 0.88 % 2015(YTD) + 0.20% 2nd Qtr. – 0.23%
“Déjà vu” – “Imitation is the sincerest form of flattery.” – Charles Caleb Colton, 19th Century English cleric and writer
Step Back by the FED – In a desperate attempt to prevent a financial meltdown in the fall of 2008, a team of high government officials led by Federal Reserve (i.e., FED) Chairman Ben Bernanke, Treasury Secretary Hank Paulsen, and New York Federal Reserve President Tim Geithner worked feverishly to devise a plan, which would shore up a financial system on the verge of collapse. Their finger-in-the-dike program was the Troubled Assets Relief Program (TARP). It authorized the expenditure of $700 billion to purchase questionable assets from banks. Although this program helped to prevent a financial meltdown, the economy continued to flounder. In a further attempt to boost confidence, FED Chairman Bernanke initiated a program referred to as quantitative easing. The purpose was to create more liquidity in the banking system by purchasing securities from the banks, and therefore allow banks to increase their lending volume. Simultaneously the FED lowered the FED funds lending rate to zero. A slack economy coupled with these aggressive FED programs has resulted in a prolonged period of very low interest rates. Beneficiaries of this government largess include banks, large corporations, and borrowers of all size. Savers have been the big losers. For the past six and a half years these efforts have continued, yet they have yielded scant benefits to the country at large.
In spite of this inauspicious performance, recovery in the United States has surpassed what many other countries were able to achieve during the same period. In order to rejuvenate their economies, a number of these countries have decided to imitate the low interest rate, easy money policies that have been the primary focus of this country’s recovery efforts. Japan, the European Union, and even China have decided easy money is the answer to their economic ills. The simplest explanation is they have evaluated “better performance” on a relative scale rather than an absolute scale. During this period, the U. S. economy has struggled to sustain any positive momentum yielding the weakest recovery of the post- World War II era, yet Japan and the European Union as represented by the European Central Bank have made efforts to mimic the practices of the U.S. Federal Reserve. China’s picture is fuzzier because growth has not been the issue rather it is potential bubbles that have surfaced in its real estate and the stock markets.
Juxtaposed with this movement elsewhere in the world is the decision by the Federal Reserve and its Chair Janet Yellen to alter course and begin to raise interest rates. Why? The FED has gradually come to the conclusion that it is time to allow market forces to have a greater voice in the proper level of interest rates. This is not to say all members are in agreement with that stance. Some members believe rates have been kept too low far longer than necessary, while others fear any rise in interest rates will jeopardize this feeble economic recovery. The inability of the President and Congress to agree upon any substantive policies to rejuvenate the economy has left the burden largely on the back of the Federal Reserve, and they are only able to employ a few blunt tools to accomplish this challenge. Now the silly season of politics is about to begin. The likely result is each party can be expected to retreat to what they regard as safe ground from which they will lob brickbats at one another. Consequently, the economy will be on autopilot until November when the President and Congress try to agree on an increase in the nation’s debt ceiling.
Market Past and Future – The performance for the first six months of 2015 is easy to summarize – moments of excitement resulting in minimal overall progress. Neither the Dow Industrial nor the S&P 500 was able to achieve a noticeable gain during the period, yet the NASDAQ (formerly referred to as the “Over-the-Counter Market”) registered a respectable 5.3% gain. Much of the credit for its gain is due to the strength in social media and biotech stocks. Both of those sectors can be fairly described as highly volatile with above-average risk. Both offer little or no dividend return.
What Do Stocks Offer? After an uninspiring performance in the first half of the year, investors are questioning what it will take to lift equities out of their current malaise. Will it require a more vibrant economy; better corporate earnings; or merely a revival of consumer confidence? Without some improvement in investor sentiment, the next few months will be a serious challenge because August and September have historically been two of the weakest performing months for stocks. Another negative factor hanging over the market is a deterioration in market breadth. This involves comparing the number of declining stocks to the advancing ones, which provides an insight whether buyers or sellers predominate. Sellers appear to have the upper hand as witnessed by the fact the NYSE daily advance/decline line has been trending lower since late April, and market leadership is being concentrated in fewer companies.
Corporate results for the second quarter have tended to reinforce this uncertainty. As reported thus far (early August), corporate revenues have declined 3.3% and earnings have advanced a paltry 0.9% during the quarter. Key sectors inhibiting growth in the stock market averages are energy and materials. In spite of the continuous haranguing by politicians in Washington, banks have been among the market leaders this year along with a good representation of technology companies, particularly those in the social media field. Until there is more convincing evidence of improved growth in the economy, a prudent approach is to adhere to a middle-of-the-road policy emphasizing large, quality, dividend paying companies.
Interest Rate-mania – After six frustrating years, fixed income investors must feel they too are “Waiting for Godot.” FED Chair Yellen has offered a ray of hope to them by stating the FED intends to institute its first rate increase by the end of the year. Market observers have been playing a guessing game. Will it be this quarter? Next quarter? By the end of the year? She has gone to great pains to explain additional increases will be data dependent and will most likely be gradual. As opinions have moved along that time continuum, interest rates have risen and fallen. Presently, the consensus seems to be the first increase will occur in September, however the FED is quick to add that it expects future increases to occur at a measured pace determined largely by the pace of economic growth. Although Ms. Yellen and the FED have gone to great pains to prepare the markets for this sea change, there remains a surprising amount of angst among some market observers. A knee-jerk reaction may happen when the increase is announced, but it should not have a meaningful impact on the fixed income market or stocks.
There is no reason to expect we will experience a quick return to those salad days of yesteryear when a safe, secure CD or U.S. Treasury provided a satisfactory return of five percent or more. The reality is short-term rates are not expected to rise very much nor are longer rates. In spite of this subdued outlook, the greatest risks are associated with long maturities (greater than 20 years) and lower quality (high yield or junk bonds). This is due to the anomaly of the drastic tightening of interest rate spreads, which is particularly evident in the preceding two categories. If you assume greater risk, you normally expect greater return. However any added return has shrunk to miniscule levels. Given the current risk-reward relationship in the bond market, the best advice is to favor safety and liquidity over reaching for extra income. On a relative basis, the only segment worthy of our recommendation is municipal bonds, and they are primarily of benefit to those in the higher tax brackets.
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