June turned out to be another good month for equities as all the major indices we follow – domestic and foreign – trended higher. At the same time bonds, as measured by the Bloomberg Aggregate Bond Index, caught a bid. Both the U.S. dollar and commodities continued their poor 2017 performance with continued losses.
U.S. & International Stock Market Index Returns
|S&P 400 (Midcap)||0.83%||5.18%|
|S&P 600 (Small Cap)||0.53%||2.13%|
|Barclays Agg. Bond||2.27%|
|CRB Commodity Index||(9.21%)|
|U.S. Dollar Index||(6.01%)|
Source: Morning Outlook July 1, 2017
The first six months of 2017 have been kind to equity investors. Solid gains abound for both US and global equities as the majority of the indexes we follow have seen average yearly gains in just the first half of the year. Lagging are the small cap and mid cap indices, which after strong gains in 2016 have consolidated thus far in 2017. Our thesis since November 2016 has been higher stock prices as long as the market believes health care reform and tax cuts are coming. So far the markets still believe.
Looking at the charts everything looks quite boring. From our seats it feels like complacency. More to the point, equity investing feels like it is at the exact opposite end of the emotional spectrum than we witnessed at the March 2009 market bottom. After more than 500 days without a 10% correction in the S&P 500, new highs continue to come.
When will it stop? Your guess is as good as ours.
The long-term trend continues and can continue on for longer than you would reasonably expect. Fundamentals (earnings) are the driver of long-term equity pricing. In the short and intermediate-term, however, the charts can be a good guide. So while the charts continue to issuing warning signs there is no reason to panic. The big trends enter the second half of the year still intact.
As boring as the equity charts were this month the bond charts are flashing change. The 10-year Treasury yield fell as low as 2.10%, closing a gap in yield dating back to November 2016. By the end of the month yields had reversed higher, closing the month yielding 2.30%. Technically this is significant but not surprising. With yield bouncing higher to end the month, July could be a month of real change in yields … or not.
If the move higher continues we see 2.60% and 3.00% as the next two levels of resistance. While this would be bad for bondholders in the short-term (as yields move higher the price of bonds moves lower), it is probably a very good thing for the economic outlook. As we mentioned in the May 2017 report, the yield spread between 2 year and 10 year Treasuries was tightening. This flattening of the yield curve makes it harder for lenders to earn income from lending money to borrowers, eventually leading to a slowdown in credit and then a slowdown in economic activity. Fortunately with the turn in the 10-year Treasury yields came a widening of the spread. In July we look to see if these are short lasting developments or a longer change in trend.
The world is connected in ways which are not always obvious on the surface. In the case of the falling US Dollar the direct link is the tightening spread between US Treasury yields and corresponding yield of global bonds. With European leaders expressing the desire to end their form of quantitative easing, the yield on European debt has increased in the past few weeks. As a result the dollar continued to move lower vs. a basket of foreign currencies in June. Downside support is in the 92-93 area.
Continuing on with the theme of intermarket relationships, the commodities market and the US Dollar tend to move in opposite directions. Dollar higher generally means commodities lower, and vice versa. This works over long periods of time with divergent action from time to time.
The 18+ month consolidation we have been following was broken in June as commodity prices fell below the lower trend line. This is counter to what the US Dollar is telling us. A continued weak US dollar should help turn around commodities, although the timing of such a move is hard to predict.
To put it in plain and simple terms, we remain short-term cautious. It is summer after all, a time when investors start to lose focus on their investments as vacations, back-to-school and other pressing matters take over. July has generally been an OK month but begins the “worst four months” of equity returns (Stock Trader’s Almanac 2017 pages 58, 60, 148).
In our opinion, what happens over the next few months is unlikely to change the positive posture of the equity markets. We could experience a typical year with volatility in stock markets in the coming months, even a possible correction. Or, historical precedence could be wrong for 2017 and markets continue to reach new highs. Right now, however, what is on our mind is the long game for our clients. Specifically, we are concerned about what we believe is the most pressing issue for investors these days: the prospect of low future returns.
Complacency feels good and right now, things feel really good. New highs are occurring on a regular basis while yields on bonds and bank issued CDs have been moving slowly higher. After 8+ years of positive markets, who can complain?
Well … bond yields are low and will remain low for some time. For almost 30 years the income investor could expect to receive a reasonable coupon rate with the added benefit of some capital appreciation on the bonds owned either outright or through a mutual fund. In the not so distant past it was not unreasonable to expect a high quality bond portfolio to return between 6% and 8% per year. Today one should reasonably expect to get somewhere around a 3% yearly return for the foreseeable future. Clearly this is not your grandfather’s bond market.
Just as bond yields are close to historic low levels, stocks are currently trading at high valuations. Historically, we know that from these levels a reasonable expectation is 4-5% per year from equities. Make some smart tactical decisions and the investor would have the opportunity to boost those numbers. Make a few bad allocation decisions and all of a sudden 4-5% sounds pretty good.
This is something Magellan Financial has been thinking about for the past few years and you will be hearing more from us on in the future. As your trusted advisors, thinking about the big picture – about the long game – is part of our value. It is easy to get complacent when times are good and reactionary when things are not so good. Yes, managing a portfolio over the next few weeks is important. Managing the coming years, however, is crucial to long-term success.
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Robert I Cahill, Managing Partner Rob.Cahill@wfafinet.com
Jeffrey T. Bogert, Partner
Jonathan D. Soden, Partner Jon.Soden@wfafinet.com
Robert Sweeney, Financial Advisor Bob.Sweeney@wfafinet.com
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