Summer’s Hot Issues

On May 21, 2015, the S&P 500 Index closed at 2,130.82, an all-time closing high for this broad measure of 500 large U.S. companies (St. Louis Federal Reserve).

In the year since, it has failed to recapture that level.

On April 20 of this year, we finished at 2,102.40 and we closed out May at 2,096.96, but there hasn’t been a new high in over a year (St. Louis Federal Reserve).

It’s not uncommon for the major indexes to go through periods where gains are elusive or we experience unwanted volatility.

According to research provided by LPL Financial Research, there have been six instances since 1984 when stocks failed to top an all-time high within a year, including the current one. During 1984, 1988, and 1995, the S&P 500 posted gains that ran from 9.9% to 18.2% in the following six months.

But shares lost ground during 2001 and 2008, as the economy was sinking into a recession.

I won’t try to predict where shares will be in six months, but most leading indicators aren’t pointing to a recession.

That leads us to the next question, “Why have the bulls seemingly been taking an extended nap?”

There are a number of reasons, but let’s hit on the major ones

1. S&P 500 profits have declined for three straight quarters (Thomson Reuters).
2. An earthquake in the oil industry has rippled through manufacturing, which has also hampered profits.
3. The stronger dollar has hurt earnings of U.S. multinationals, because sales incurred overseas must be translated back into the stronger dollar.
4. A lackluster U.S. economy is a headwind to revenue and profit growth.
5. Lingering worries about global economic growth hamper overall sentiment.
6. There is election year uncertainty.

On the flipside

1. The earnings recession is expected to run its course during the current quarter (Thomson Reuters).
2. Oil prices are well off the lows, which loosens the tight screws around the industry.
3. The dollar has stabilized.
4. Leading indicators are not pointing to a recession.

There’s not much positive to say about the global economy. As far as the election, I’ll leave that to the political pundits.

Table 1: Key Index Returns

	MTD %	YTD %	3-year* %
Dow Jones Industrial Average	+0.1	+2.1	+5.6
NASDAQ Composite	+3.6	-1.2	+12.7
S&P 500 Index	+1.5	+2.6	+8.7
Russell 2000 Index	+2.1	+1.7	+5.5
MSCI World ex-USA**	-1.7	-1.6	-1.0
MSCI Emerging Markets**	-3.9	+1.7	-7.2

Source: Wall Street Journal, MSCI.com

MTD returns: April 29, 2016-May 31, 2016

YTD returns: December 31, 2015-May 31, 2016

*Annualized

**USD

 

Summertime blues: Brexit

At this juncture, let’s take a look ahead and spend some time on a couple of issues that have the potential to create short-term volatility in stocks. This won’t be all-inclusive, but hits on the high points.

The first is the potential “Brexit,” the possibility that Britain will choose to exit the 28-nation European Union (E.U.) in a June 23 yes-or-no referendum.

The 28-nation E.U. is a political and economic alliance that allows member countries to benefit from free trade at the expense of ceding some political authority.

Most economists see problems in the short term for Britain if anti-E.U. forces prevail, but those same forces believe the removal of burdensome regulations would benefit the nation.

The OECD said at the top of the month that a Brexit “would trigger negative economic effects on the U.K., other European countries, and the rest of the world.”

But St. Louis Federal Reserve President James Bullard took a much more sanguine view last month, noting if the U.K. decides to leave, “the next day nothing happens” and the country will enter into departure negotiations that are bound to go “very slowly” (Bloomberg).

One potential unknown: Will London lose its status as a banking center? Or would British-based firms depart? Again, this has the potential to damage Britain’s economy.

The U.K.’s economy is much more important to Europe than Greece, and we may see added uncertainty if the election appears to be too close to call in the run-up to voting.

While a number of polls in May placed the “remain” camp in a reasonable lead, two Guardian/ICM polls at the end of last month suggested those who want to exit the EU have taken a slight lead.

Nevertheless, we all know the imperfect nature of polls, and campaigning will continue.

Whatever happens, a vote to leave would spike heightened uncertainty that could easily produce short-term volatility for U.S. stocks.

Summertime blues: The Fed

While the Fed is taking a very slow approach to raising interest rates, several Federal Reserve officials, including Fed Chief Janet Yellen, are seriously eyeing another rate hike this summer.

In remarks made in late May, Yellen noted it would be appropriate for the Fed to gradually lift the fed funds rate, with an increase “probably in the coming months (Wall Street Journal).”

Currently, odds do not favor a hike in June (CME Group), but July is definitely a possibility.

But let’s take a longer view. Historically, data from the St. Louis Federal Reserve suggests that, by itself, higher interest rates do not lead to bear markets (recessions do). But a second rate hike by the Fed has the potential to create short-term volatility for investors.

The long road…and Paul

For long-term investors, it’s important to look past short-term volatility and stick with a disciplined approach. As many of you have heard me say, attempts to outguess the market are usually met with frustration.

This leads me to an interesting experience I had early in the year at a meeting with colleagues. Recall that 2016 began on a rocky note and stocks quickly experienced their second correction–a decline of greater than 10%–in less than a year.

During that time, I had the opportunity to discuss the market with an advisor, whom I’ll call Paul.

[Paul shared with me that he had taken most of his clients out of stocks at the end of last year, believing that a recession and bear market would set in by midyear. His plan was to nibble at stocks following a 20% decline and get more aggressive when shares slid by 30%.

He didn’t expect to catch the bottom, but felt reasonably confident he’d skip much of the expected sell-off and reenter stocks at a lower level. It sure seemed simple.

But here lies the fundamental problem with his approach, at least in my opinion. In order to successfully time the market, you have to get it right twice: getting out and getting back in.

So let me reiterate what deep down we all know: Side-stepping corrections and finding the bottom is exceedingly difficult. More likely than not, investors find themselves buying back in at higher levels.

Traffic jams and unexpected slowdowns are sometimes encountered on the journey to one’s financial goals. Over the long term, however, a disciplined approach that eschews an emotional response has historically been the most profitable way to reach one’s long-term goals.

Market tailwinds

While there are short-term risks, there are also tailwinds that are supporting stocks.

Yes, corporate profits have been weak lately, but analysts are cautiously forecasting a return to growth by the third quarter (Thomson Reuters). Much will depend on the recent strength in oil prices, stability in the dollar, and continued economic growth at home.

Next, recent economic data have been encouraging. In last month’s letter, I delved into some of the problems with seasonality in the quarterly GDP report. GDP, or gross domestic product, is the broadest measure of the economy. Recall that over the last 25 years, we’ve witnessed a statistically significant drag on first quarter growth (San Francisco Federal Reserve). Not surprisingly, Q2 is bouncing along at a faster pace than Q1 (Atlanta Federal Reserve).

At best, we’re seeing an encouraging though cautious acceleration in the economy. At a minimum, it strongly suggests the economy isn’t set to stall. On a more practical matter for investors, it creates a tailwind for corporate profits.

Meanwhile, even if the Fed goes through with another rate hike this summer, interest rates will remain near historic lows. Undoubtedly, low interest rates have been a challenge for savers who rely on income, but low rates are supportive of stocks when the economy is expanding.

Bottom line

You and I cannot control the stock market, interest rates, or the economy. Clearly, these variables are outside our control.

What we do control is the investment plan. So I encourage you to adhere to the one we’ve agreed upon, unless you’ve experienced a change in circumstances that means we need to adjust the plan.

When stocks are galloping ahead, some clients begin asking about a more aggressive exposure to equities.  On the flipside, when shares are down, some want to take a more conservative stance. This was especially true in 2009, when we experienced the worst economic slump since the Great Depression. It was a difficult time, and I strongly encouraged that we maintain a presence in shares. While bear markets are difficult, they are an inevitable part of the investment landscape. But always remember, storms end and rainbows follow.

I hope you’ve found this review to be educational and helpful. As I always emphasize, it is my job to assist you! If you have any questions or would like to discuss any matters, please feel free to give me or any of my team members a call.

Thank you very much for the trust and confidence you’ve placed in my team here at Creative Financial Strategies, Inc.

All the very best!

Kevin

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