Mid-Year Review of the Markets June 30, 2014

The first half of the year ended with virtually all markets around the world --both stocks and bonds showing strong performance. The explanation for most of these moves centered on the “no one else to put your money” rationale with interest rates low around the world.  In early June the European Central Bank began an aggressive policy of unprecedented low interest rates . In the US sentiment in the markets is that the Federal Reserve won’t be raising rates for an extended period of time. As a consequence money flowed into stocks and riskier portions of the bond market.

US Stocks.

·         The broad US stock market once again put in a strong performance the US total market index (ETF ticker VTI) is up 7% ytd. Large cap value stocks and small cap value outperformed the overall market.

·         By virtually all measures the US stock market is highly valued vs historical levels.

The continued strength of the market can be attributed to:

·         Current low interest rates and little indication the Federal Reserve will raise rates in the near future. This is seen as a positive for us stocks.  The low rates also produce a “nowhere else to put your money  movement. The large moves in high dividend stocks such as utilities drawing investor interest and high valuations indicates investors looking for alternatives to low yielding bonds

·         Paradoxically stock prices seem to reflect optimism on the US economy.  But clear signs of a recovery would lead to higher interest rates…a negative for stocks.

·         Momentum: momentum is certainly a factor affecting market returns in the short term. At this point the US market shows strong upward momentum including flows into the market who have missed much of the stock market’s gains by avoiding stocks.

·         The combination of high valuations and a momentum driven market creates the conditions that could easily lead to a market selloff even if only short term. In the long term price reflects value and US stocks carry high valuations.

International Stock Markets

Emerging Markets:

·         After an extended period of underperformance vs the US, emerging markets have had a sharp rebound this year. Emerging Asia (etf GMF) is up a bit more than the US this year although the overall emerging markets still lag (etf IEMG).

•            With interest rates low around the world the fears associated with the negative impact of higher interest rates has dissipated.
•          Sentiment towards economic fundamentals in many parts of the emerging economies has turned more positive.
•          Emerging markets show the most attractive valuations globally trading at a valuation discount of around 25% vs the US and 20% vs the broader European market

Emerging markets are characterized by large “hot money flows” quick to sell in down markets and quick to buy in when performance turns positive. Judging by data on inflows into emerging market stock funds and ETFs this buying cycle seems to be in place. But investors should make sure they understand the volatility of these markets and have a long term commitment to their allocation in these stocks.

European Markets

·         In early June the European Central Bank (ECB) initiated an unprecedented program of low interest rates and other policies for monetary easing. There is every indication that low European rates will continue well after the US enters into any reversal of low interest rate policies.

• ·         The June 2012 ECB declaration of “doing all that it takes” to stabilize the European economies set the stage of a strong rebound of European stocks recovering from losses during the 2011 crisis. It remains to be seen what the effect will be on stock markets. But the move immediately led to strong increases in prices drops in yields.
•        With valuations in Europe lower than US markets and continued low rates it seems the environment is positive towards European stocks.
•          Although the Euro area index (ETF ticker  FEZ)has underperformed the US year to date it has outperformed the US over the last 12 months
•        In 2014 both Italy and Spain have rebounded sharply reflecting sentiment that the worst is over in terms of the crisis conditions in the European financial markets of 2011.
•      T he US central bank is towards the end of its aggressive low interest rate policy and the ECB committed to expanding its monetary stimulus for an extended period into the future. That might set the stage for outperformance of the European markets.

Returns for Selected Stock ETFs

Stocks:	ticker	ytd	1 yr	3 yr
Total US	vti	7	25.4	60.9
Large Value US	prf	7.4	24.9	63
Small Value Us	vbr	8.4	28.4	63.2
Emerging Asia	gmf	7.7	16.9	8.9
Total Emerging Markets	iemg	4.7	14.3	10.4
Euro zone	fez	4.9	34.6	26.6

Bond Markets

The “market consensus” of both traders and economists at the turn of the year was that longer term rates would rise in 2014. Perhaps not surprisingly so far this year the market has moved sharply in the other direction.

• Ten year US Treasury bond rates were at 2.6% at mid-year and reached just under 2.5% during the first half of the year.
•    Part of the price movement doubtless reflects the reversal of positions by major short term traders unwinding positions aimed at profiting from higher interest rates. The poor performance by hedge funds and others trading in bonds reflects this.
• While it is difficult to find a rationale for a long term buy and hold investor to buy a ten year treasury bond with a 2.6% yield it does not mean traders might not push yields even lower.
• The Federal Reserve has indicated that the move to higher short term interest rates will come slower than some may have expected although it will continue “tapering” reversing its purchases of longer term bonds.
•   In a search for yield investors have moved large sums into riskier assets such as bank loans, high yield bonds and emerging market bonds. As a consequence interest rate differentials between these instruments (spreads) and treasury bonds has narrowed consistently.
•  Investors adding these assets to their portfolio should be careful to monitor their risk and balance their portfolio with lower risk short duration bonds despite their unattractive current yields.
•  Investors in emerging market bonds should take into account the high volatility of these bonds including additional currency and political risk.

Bonds	ticker	ytd	1 yr	3 yr
Short Term High Yield	hyd	6.7	15.3	33
Short Term Inv Grade	vcsh	1.5	3.5	9
Short Term Govt	vgsh	0.2	0.5	1.4
Aggregate US Bond	AGG	3.8	4.4	10.2
US Long Tern treasury	TLT	12.9	6.1	29.8