Investment Outlook for 2nd Half of 2014:
INVESTMENT MARKETS RECEIVE SUPPORT BUT MAY LIKELY BE CHALLENGED BY HEADWINDS
What happened the first half of the year? Profits for the 1st quarter of 2014 were actually better than expected, despite the country’s deep freeze. The blizzard conditions shut down the transportation of goods and services. Healthcare spending was lower than expected and inventories were drawn down. We had market declines in February and April which were read as distractions to what continues to be a generally solid, yet moderate, economic recovery. April’s decline was the 7th drop in the market in the 3-8% decline range over the last 36 months. Clearly, the US economy dropped into a hole, as evidenced by the 1st quarter seasonally adjusted GDP decline of 2.9%. However, the market’s declines were very slight relative to the very large stock gains in 2013. Perhaps the declines were muted due to the more promising outlook for the 2nd quarter and second half of the year. Also, large volumes of company stock buy backs kept values buoyant.
What’s going right? Presently, we are having a stronger rebound from a deeper hole. Using the stock market as a leading indicator – up about 10% since the February low and 7.5% from the April low –suggests that second quarter earnings will be better than expected. If we focus on leading indicators, irrational pessimism should again be disproven suggesting a US growth rate of 2.5% to 3% - slow and steady – and global expansion in the 6-7% range with support from China’s stabilizing growth. The Federal Reserve has communicated no immediate plans to raise interest rates and the global central banks continue maintaining a policy to keep rates very low; no recession on the horizon, stock valuations are not euphoric and have been correcting in pockets of market froth; investor sentiment is reasonably balanced; industrials and transportation sectors are pretty solid. The momentum going into 2nd quarter earnings is positive with increasing gains in employment and improving consumer sentiment.
What are the concerns? If profits start to disappoint along with corporate outlooks softening, stocks may sell off. Assuming this does not happen, event driven market declines such as geopolitical noise are likely buying opportunities. Structural economic changes such as interest rate increases or a sustained spike in oil prices are a bigger concern. Geopolitical risk, primarily in the Middle East, could result in spiking oil prices. This could send Europe into a recession and would have a negative effect on the US economy and equity markets. The Federal Reserve may be behind on raising interest rates and communicate the rate increase sooner than what the financial markets expect, resulting in a rapid and possibly deeper market decline. Both of these could lead to a structural change and effect the economic recovery. Assuming neither one happens, market gains may grind forward leading to higher valuations and possible bubbly conditions. Rates rising sooner may likely slow the economy and cause a market correction but limit possible bubble scenarios in the longer term.
Allocation of funds? Cash provides a negative return after inflation. US government bonds are likely overvalued to stocks, however the interest rate bottoming process may go on for quite some time. Although various stock valuation methods present a range from overvalued to fairly valued, there are select U.S., developed and emerging market stock sectors that appear attractive, assuming the trend of global recovery continues. Expect headwinds that could lead to stock declines, perhaps shallow and in short duration. Assuming nothing structural, it may be an opportunity to reallocate and reinvest. NOTE: CUSTOMIZED CLIENT INVESTMENT POLICY MODELS ARE CONSERVATIVE WITH PRESERVATION OF PRINCIPAL, CONSERVATIVE, MODERATE AND MODERATE PLUS.
Steve Erken CFP® Principal
July 18th, 2014