Index Performance
Securities markets the second quarter of 2016 were tepid, as we have come to expect. Aside from a quick spike downward thanks to Britain’s decision to leave the European Union, stock and bond markets were able to add to their meager first quarter gains. The S&P 500 finished the first half up 2.7% and the Dow Jones Industrial Average likewise finished up 2.9%. Technology stocks, in contrast to last year, have fared poorly. The tech-heavy Nasdaq index has thus had a difficult year and finished down for the half -3.3%. Also, in contrast to 2015 when large cap growth stocks outperformed every other asset class, in 2016 these same stocks are underperforming every other category. The growth-oriented Investor’s Business Daily Mutual Fund Index gained a little in the second quarter but still finished the half in the red, down -1.6%. Given the first half’s volatility, traders – especially foreign traders – are still seeking the relative safety of bonds. The Barclays Aggregate Bond Index closed out the first half beating all stock indexes to be up 5.3%.
Markets Display Their Resilience in First Half
This year’s markets so far can be summarized in one word: resilient. Against the backdrop of lagging economies worldwide, international political tumult, and an uncertain domestic political future, our markets trudge on. These are all the same headwinds to which we’ve become accustomed these past two years; they are nothing new and domestic stocks have held firm against them. Notwithstanding the dire predictions of the bears – who start their rumblings every time some unforeseen event causes a temporary sell-off – the indexes have recovered and are nearing new highs. Compared with the wild ride of the first quarter, the second quarter was relatively stable. Aside from a shocking vote in Britain (see Brexit below) there was no economic event significant enough to move markets either up or down. As has become custom, traders looked to the Federal Reserve for some guidance but were yet again left wanting. Oil roared back but the close correlation between the stock market and the price per barrel has since faded; thus stocks are mostly flat while the energy sector has been one of the top performers of the year.
Now that 2016 is half over we are encouraged by the market’s ability to drift higher and not sink despite the weight of all of the negatives thrust upon it from abroad. Indeed, the past two years the domestic stock market has evinced an uncanny capacity to recover from disruptions and maintain a mildly positive trajectory. We believe this resilient lull to be the market searching fervently for some catalyst for growth. In the following we will examine the second quarter’s performance to determine what it might mean for the second half and if the catalyst for growth can be uncovered.
The Federal Reserve Postpones Rate Hike
What little volatility we experienced the past three months was mainly in anticipation of and in reaction to the actions of the Federal Reserve (the Fed). You will recall that last December the Fed raised short term interest rates to a range between .25 and .5%. At that same meeting the Fed announced plans to raise rates four times this year so that the target by year-end 2016 would be 1.375%. Alas, we are halfway through the year and the Fed has yet to touch rates. At their most recent meeting in June Chair Janet Yellen and her cohort of Fed presidents voted unanimously to keep rates unchanged. The market shrugged, quite unlike the 6.6% monthly market gain following March’s hold-steady announcement. In fact the June announcement helped contribute to the market’s first five-day losing streak since February. Nonetheless, following the five-day losing streak the stock market quickly returned to form proving its mettle notwithstanding our central bank’s timidity.
What explains the disparity between the two reactions to an avowedly dovish Fed? After all, low rates are usually viewed as favorable to equities even if the Fed blames poor economic conditions for the delay. In all likelihood investors seem to have come to the undesired conclusion that our low-growth economy is not something the Fed has the tools to fix. Now whether or not market participants are correct to seek economic salvation from our central bank overlords is a question for another day. What is not an open question is the fact that the Fed no longer leads the markets, the markets now lead the Fed. The employment rate is full and inflation is increasing – fulfilling the “dual mandate” – yet the Fed has continually put off raising rates, seemingly in reaction to market gyrations. After so much hemming and hawing and persistent jawboning from hawks and doves, the Fed finally exhausted its ability to appear as an authority on the health of the economy. Chair Yellen summed it up at her post-meeting press conference: “We are quite uncertain about where rates are heading in the long term.”
Oil and Stocks No Longer Strongly Correlated
The respite from volatility we experienced in the second quarter was achieved partly from oil and equities once again moving independently of one another. When crude hit its bottom in February the commodity and stock market moved in tandem nearly 75% of the time. Energy being one of the most volatile sectors, the correlation transferred this volatility to the broad stock market. This atypical correlation was a function of the historic lows that oil was dropping to. Such lows sparked fears of flat demand, energy bankruptcies, and the domino effect a failing sector could feasibly trigger across all parts of the economy.
The correlation broke down as oil climbed 83% from its low and 26% in the second quarter alone. A barrel of oil has since found a comfortable equilibrium price of right around $50. While the energy herd has been culled of the more reckless shale drillers (around 60 have gone bankrupt), the energy sector’s biggest names survived the downturn and are starting to invest in significant oil projects around the world. The bruised North American shale oil survivors have adapted and are preparing to increase efficient production as prices continue to climb. And, as reported on the Fourth of July, the United States has more estimated recoverable oil reserves than major producing nations like Saudi Arabia and Russia. The American shale oil revolution has lived up to its name: not only did it cause the precipitous drop in global oil prices, it also turned OPEC into a relic of the 20th century and has experts contemplating peak oil demand instead of peak oil supply.
Brexit Shocks Markets…Temporarily
With oil having found a sustained price level the market’s attention, and direction, then turned to Britain’s referendum on membership in the European Union. Both major political parties (Conservative and Labour), much of the media, and multinational corporations urged Brits to vote Remain by emphasizing an economic parade of horribles that would result from a Leave vote. Even though polls were close going into the vote the British people’s decision to leave the EU stunned observers worldwide. The silent majority – mostly English – made their voices heard and Leave triumphed 52 to 48. Preliminary analysis reveals several factors that weighed on Leavers minds as they cast their votes. First, proud Britons chafed at the idea of the land of the Magna Carta and of John Locke being ruled over by unelected Continental technocrats to whom the idea of the state being subservient to the people is a foreign concept. Next, Brits considered the economic implications and decided that going it alone may be a more promising future than continuous Euro-bailouts – funded primarily by Germany and Britain – of failing socialist Union member states. Finally, and perhaps most importantly, British people observed the profound bungling of the migrant crisis by Angela Merkel and the Euro-elite and had simply had enough. The UK government has two years to complete exit negotiations with the EU. There is no cause to worry about immediate market implications though we can expect increased volatility owing to the exit process for the next couple of years.
Despite all of the doomsday scenarios being floated by the Remain camp, capital markets were able to absorb the shock of Brexit and recover enough to close the quarter in the green (the vote was on June 23rd). Both the S&P 500 and Britain’s FTSE-100 index fell 5% the first two days in the wake of the vote. These “fear” trades were very soon realized to be overdone as participants recognized that Brexit’s effects will most likely be socio-political rather than economic. After all, the UK is Europe’s second-largest economy and the slow-growth EU is assuredly not going to spite such a vital trading partner; as much as they would like to, they simply cannot afford to. The more clear-headed markets then started buying again and the FTSE-100 recorded its best weekly performance since 2011. The resilient American markets similarly took the vote in stride and quickly recouped the losses suffered in the immediate emotional aftermath.
Technical Analysis
From a technical perspective the second quarter markets appeared to be in a holding pattern. The pessimist would say the market is stuck in quicksand and ready to sink at the slightest flailing. We, however, see reason to be optimistic. The market may be in a holding pattern but it has survived numerous threats only to maintain its bullish slant. Both the S&P 500 and the Dow indexes ended the quarter above their 50-day and 200-day moving averages. We note that both indexes had fallen below these indicators only three days prior to the end of the quarter owing to the Brexit vote. The resilient markets again displayed their stamina as they rallied to overtake the indicators and closed the first half of the year on a decidedly bullish note. Because of economic and political turmoil overseas and the steady growth of American business, our markets succeed by default. Not only is this true in the stock market, it is undoubtedly the case in the bond market as well.
In last quarter’s newsletter we detailed the negative interest rate policies that central banks around the world have instituted. The idea behind this “stimulus” program is to encourage money flow through the economy – banks don’t want to pay to sit on cash so they’ll loan it out. Add to this policy remarkable levels of quantitative easing (central bank bond purchases) and you have a recipe for historically low bond yields. Bond yields fall as prices rise. Global investors lack confidence in equities and have sought out the safety of bonds this year. Because of quantitative easing they are competing with the unlimited resources of central banks so prices have skyrocketed causing yields to sink. Much of Japanese and European sovereign debt is now issued with negative yields (i.e. bond-holders will lose money on their loan). All told there is nearly $12 trillion in outstanding negative-yielding debt. This unprecedented number has led distressed investors to the one place they can find yield: the United States.
Thus have the prices of Unites States Treasuries climbed higher while yields have fallen to record lows. As of this writing in early July the yield on a 10-year Treasury Note has hit an all-time low of 1.366%. American markets are in the peculiar position where the normally non-correlated equity and fixed income markets are both rising at the same time. Domestic investors are seeking yield and growth opportunities in stocks while foreign investors are piling into the safety of US government bonds. The second half of 2016 will be interesting to behold.
Key Economic Indicators
First quarter gross domestic product came in at a paltry 1.1%. This marks the fifth straight year that first quarter growth has failed to top just 2%. In fact, since the recession of 2008, first quarter GDP has broken the 2% rate only one time in 2012; all other times the figure has been disappointingly weak, and has actually been negative three times. The 1.1% figure, though, is an upward revision to previous lower estimates. Consumer spending on discretionary items and services was higher than had been thought and exports increased. Despite the upward revision business investment again declined and the growth rate of consumer spending was the slowest it has been in two years. The malaise of these post-recession years shows no signs of abating: preliminary estimates of second quarter growth are hovering right around 2%. The first advance estimate is due July 29th.
Gross Domestic Product
Fourth quarter 2015 GDP estimates were revised upward but still proved underwhelming. In the final analysis of how the last months of the year performed, GDP was found to have advanced 1.4%. The bump in the estimate – from 1% to 1.4% – was attributed to stronger than predicted consumer spending. Consumer spending, however, was mild considering the substantial windfall of cheap fuel prices. While holiday season expenditures propped up the GDP number, America’s businesses took a drubbing. Corporate profits fell 3.6% for the quarter year over year, and declined 8% from the third quarter to the fourth. Business investment, or the money that American businesses put toward expansion and growth, similarly declined. The post-recession economic malaise looks as if it will persist as advance estimates for first quarter 2016 GDP are again predicted to be below 2%. The Federal Reserve Bank of Atlanta has continually downgraded their projection for first quarter GDP growth and as of this writing they anticipate a weak .1% growth rate.
Employment Situation
Although the economy is lukewarm, it has at least been consistently so. Nearly all fronts exhibit mild growth, from consumer spending, to housing prices, and of course to employment. Bearish warnings of a recession on the horizon appear to be impulsive emotional reactions to overthought events (e.g. Brexit). We need only consider the health of the domestic labor market: as one economist notes, our labor market, “remains a bright spot.” The unemployment rate for June stands at 4.9%, a number that is within the Federal Reserve’s target range for their definition of “full employment.” Recall that the first half of the Fed’s dual mandate is to “foster maximum employment,” so these latest numbers should reassure Chair Yellen as to the persistence of our bull market.
We also note the disastrous employment report from May when only 11,000 jobs were added. Economists had predicted 158,000 new jobs and when the actual number was reported it briefly cast a pall on the economy – though our resilient markets mostly ignored it. The stunningly low May number appears to have been an aberration as June’s actual number of jobs added (287,000) was a full 120,000 over initial predictions. The second quarter as a whole averaged 147,000 jobs added per month, which is less than the first quarter and last year. However, these lighter gains may be indicative of the aforementioned “full employment” number rather than a declining economy. It stands to reason that fewer jobs will be added when every willing and able person is already working. In any event, both the steady job gains and low unemployment rate signal that this economy is still powerful and the labor market is most certainly a contributing factor to our markets’ tenacity.
Consumer Confidence
Consumer confidence remains elevated, though it has dropped from its apex reached last year. The University of Michigan Index Of Consumer Sentiment recorded a 93.5 for June, down from 94.7 in May. The number is above the non-recessionary year average (87.5) so it indicates that consumers are reasonably optimistic about the outlook of the economy. The index has been steady since January, mostly in-line with our mild GDP growth. Early reports are showing consumers are beginning to spend more this most recent quarter even though wage growth has been slow-going.
Looking Forward
Below we present a graph of the S&P 500’s performance since the end of 2014. You can see that these past 18 months have been particularly volatile.
The red line on the graph represents the closing price from December 31, 2014. Observe that the market has struggled to return even 2%, and were it not for the post-Brexit rally the index would be down 2% from its price a year and a half earlier. Further, notice that the majority of volatility has been on the downside, underneath the red December 31st line. What we want to see is progressive volatility instead of this regressive volatility. With regressive volatility we see significant downward spikes and crawls back up to the mean but nothing more. Progressive volatility is a consistent, though not absolute, climbing trend above that red line. Before 2015 this progressive volatility helped the market reach new heights only to stall out last year. When we speak of a resilient but stagnant market this is the behavior to which we are referring.
Admittedly these pages have been bearish these past several quarters. We have been frustrated by the market’s stagnancy, by central bank reticence, and our political leaders’ less than inspiring grasp of economics. Still, the last year and a half – and this second quarter in particular – has given us reason to be hopeful for the future. The theme we have stressed in this newsletter is Resilience: this market takes a licking only to reclaim its losses the next day. This consistent resilience has given us confidence in the market. The American securities market has plowed through a host of obstacles thereby proving its intrinsic value. The current index levels are a foundation on which further growth can be built. All they need is a nudge: an easing of regulation, tax reform, virtuous leadership, confident central bankers or technological innovation. Any one of these things has the ability to give markets reason to break out of their complacency and charge forward into a brighter future.
