Two
weeks ago in the latest GDP update, the U.S. economy was reported to have
shrunk by the most since 2009. Last week, the U.S. Stock market finished
its strongest second quarter since 2009. As Iraq seemed to all but spin
out of control and Ukraine remains unresolved, stock market volatility declined
to its lowest in seven years. And as CPI inflation rose faster than it
has in three years, Treasury yields fell to their lowest levels in a year.
Don't
try to think too much about this. There's a single common denominator for
disconnected market buoyancy: the Federal Reserve’s easy monetary policies.
This policy may be winding down, with an all but announced expiration
date. But it's still distorting markets. We've seen this
before, and we know it’s very unlikely to end well ... at some point.
But
that point can be a long time coming. In the meantime, one gauge of
market distortion is a measure of valuation popularized by Yale professor Dr.
Robert Shiller. He recently pointed out that on that basis the current
high level of market valuation has been seen exactly three times before: in
1929, in 2000, and in 2007. Investors may have collectively forgotten
their Santayana (“Those who cannot remember the past are condemned to repeat
it”), but we’re obliged to take our bearings from more than just the past few
quarters.
That
said, it should be noted that high valuations might persist for a long time
should currently low interest rates persist for many years. We certainly
don’t know what path rates may take. But in that event, stock returns are
merely likely to be low for a long time (low dividend yields with slow long
term economic growth) which certainly beats the alternative (low dividend
yields, slow economic growth, and valuations adjusting downward).
Current
conditions, of course, are not all dreary. Home sales are picking up, the
unemployment rate is down to 6.1%, private sector hiring in June was very
strong, and virtually all observers expect the first quarter’s steep declines
in GDP to have been just a weather-related blip. But future long-term
returns are never a function of current economic conditions. Future
long-term returns are, more than anything else, a function of starting
valuations. And current valuations dictate that we approach markets with
caution from a long-term perspective. Yet in spite of a lack of
compelling opportunities across the entire investment spectrum, the opportunity
cost of holding cash with zero yield requires that any such caution be modest
in degree.
In sum, the preceding is but a long way of saying to enjoy the ride - while it
lasts - but prepare for potential setbacks in the near term and lower returns
in the long run.