My F&M

Market Commentary 2nd Quarter 2014

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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.