Mid quarter stock market update

2014 Mid-Year Investment Outlook

After a difficult first quarter for businesses in which large parts of the country were locked down in the ‘polar vortex,’ the second quarter delivered a nice springtime rebound for the U.S. economy.  After diving at an annual rate of 2.9% in the first quarter, U.S. GDP looks set to rebound at a 3% rate or so in the second quarter.  Equity markets were sunnier as well as the Dow Jones Industrial Average gained 2.2% while the broader S&P 500 Index rose 4.7%. Volatility also dropped to very low levels.  The S&P 500 Index went 51 consecutive trading sessions without a 1% move either up or down; this is the longest such stretch in 19 years.

If there has been a major surprise in financial markets so far in 2014, it has to be that U.S. interest rates have actually declined significantly since the start of the year.  The yield on the 10-year Treasury was 3% on January 1 but it ended June at a yield of 2.51%.  With unemployment continuing to drop (it hit 6.1% in June) and inflation rising from 1.6% in January to 2% in May, interest rates had all the excuses they needed to rise 50 basis points—not drop 50 basis points.  The Fed’s dovish tone seems to have convinced investors that interest rate increases are still many months off.  A widely held-view among economists is that the Fed will not begin to raise rates until mid-2015.  However, if the economic data should continue on their current trajectory, Ms. Yellen may have to prepare markets for the end of zero-rates sooner rather than later.

At its June meeting, Federal Reserve officials agreed to end the bank’s bond-buying policy this coming October.  (Bond-buying in the open market by the Fed—know as quantitative easing—is intended to keep interest rates low to spur lending and investment.)  Come November, it will no longer be in the market snapping up bonds.  But it will have about $4.5 trillion worth of bonds on its balance sheet that it has accumulated since it began the program in late 2008.

Overseas, the continuing turmoil in Ukraine seemed not to bother markets in the least.  Like many such events, once investors are used to them they cease to play a significant role in investment decisions.  Russian stocks rose 11% in the quarter while Ukrainian stocks rose 7.1%.  In Iraq, as rapid progress by Islamic group ISIS stirred fears of an outright civil war between the Sunni and Shia, world oil prices tacked on several dollars per barrel.  However, in the last couple of weeks oil traders calmed down and prices have retreated back down to their April levels—before anyone had heard of ISIS.

For those looking dispassionately at markets, it is hard to argue that financial assets are cheap.  There is no question that extraordinary actions by central banks have helped to shape a world of strong asset prices—whether we are talking about bonds, stocks, art or real estate.  Nevertheless, since the markets bottomed in the spring of 2009, U.S. companies have spent the intervening five years getting stronger, leaner and richer.  Valuations of U.S. equities have risen, but it is also clear that the underlying companies are also more efficient, more profitable and more able (and likely) to return capital to investors in the form of dividends.  As we enter the back half of 2014, the U.S. economy continues to move in the right direction and conditions appear to be favorable for companies to continue to increase their earnings and dividends.  If growth should pick up steam in the next several months, look for the Fed to start communicating its plan to get us back to a world of normal interest rates.

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Picture of Peter Thoms, CFA, MBA

Peter Thoms, CFA, MBA

Peter Thoms, CFA, founded Orion Capital Management LLC in April 2002. Peter has extensive experience managing investment portfolios for clients pursuing a wide range of financial goals.

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