Presented by Joe Smalley, Accredited Investment Fiduciary®
U.S. markets continue their rise
June was another strong month for U.S. equity markets, as the S&P 500 Index rose 2.07 percent and the Nasdaq climbed an even stronger 3.90 percent. The Dow Jones Industrial Average was the laggard of the group, with a gain of just 0.75 percent. Markets continued to hit new records throughout the month.
For the quarter, results were even stronger, with the S&P 500 up 5.23 percent, the Nasdaq up 4.98 percent, and the Dow again bringing up the rear with a gain of 2.83 percent. Both the Dow and the S&P 500 have shown steady gains since the pullback in April, while the Nasdaq has made most of its gains in the past six weeks or so.
Market gains were driven by continued earnings growth, with an estimate for second-quarter growth of 5.1 percent, per FactSet. Despite the large number of negative preannouncements, the actual downward revisions to estimates were the lowest since the start of 2011, which was considered a positive factor. Interestingly, the indices increased even as earnings estimates declined—which has been the norm recently but can be considered a cautionary sign for the future.
Technicals remained strong, with all three major U.S. indices well above their moving averages. With the averages at record highs, there are no resistance levels above them to impede further advances, while lower levels can be expected to potentially act as support.
Developed international markets were up for both the month and the quarter, with the MSCI EAFE Index up 0.96 percent for June and 4.09 percent for the quarter. The relatively strong results came despite elections for the European Parliament that were described as a political earthquake (winners included a large Eurosceptic component), as well as the continued disappointing economic results in major European countries. In fact, to encourage growth, the European Central Bank (ECB) again cut rates and imposed negative interest rates on banks in an attempt to spur lending.
Emerging markets, as represented by the MSCI Emerging Market Index, had an even stronger quarter, gaining 6.60 percent. This was capped by a 2.66-percent gain in June. These positive results represent a recovery from the weakness of the first quarter, as emerging economies have shown continued signs of strength despite the Federal Reserve’s continuing exit from its stimulus program. Technical signs for emerging markets are positive and improving.
Fixed income was once again an interesting asset class for the quarter, with the 10-year Treasury rate defying analyst expectations and declining over the quarter, from a high of more than 2.80 percent in early April to a value of 2.53 percent at the end of June, with significant volatility during the period. (The Barclays Capital Aggregate Bond Index showed gains of 0.05 percent for June and 2.04 percent for the quarter, which marks the first time since 2012 that bonds have logged two consecutive quarters of price increases in the U.S.) The decline in rates in the U.S. was echoed by similar declines around the world, with yields in Europe falling after the ECB lowered interest rates in its bid to foster growth.
U.S. economic recovery continues despite rough first quarter
The economic surprise of the month and the quarter was the unexpectedly low final result for first-quarter gross domestic product (GDP) growth, which was revised down to a decline of 2.9 percent from a previous estimate of minus 1 percent. Although the first quarter’s weakness was well known, the magnitude of the downward revision called into question whether the recovery was faltering; the consensus, however, is that it continues and is accelerating.
The disappointing first-quarter results were largely due to weather, which was known, but also to revisions in health care spending, which was expected to increase but in fact decreased (see chart). The change appears to be due to problems with the data created by the start of the Affordable Care Act. Although we can expect larger-than-usual revisions while the implementation of Obamacare continues, the vast majority of the data for the U.S. supports an accelerating recovery.
Much of the U.S. economic data, in fact, is at multiyear highs stemming from before the financial crisis, especially in the areas of employment. For the first time since 1999, we recently had four straight months of job growth of more than 200,000, and right now the number of unemployed people per job opening is at the lowest level since May 2008. Wages and income are growing at an increasing rate while hours worked remain at the highest level since August 2008. Current data says that the recovery continues and is increasingly benefiting the average worker.
International risks move back to the forefront
Even though the revision of the U.S. GDP number grabbed headlines, markets largely shrugged it off. The real risks for the quarter were international. As previously noted, elections for the European Parliament, held at the end of May, saw anti-establishment parties gaining more representation than ever before in countries such as England and France. These results were driven largely by continued slow growth and high unemployment in the region, which, as noted, forced further action by the ECB.
Even more worrying than the European elections was the deteriorating security situation in Iraq, where Islamist militias had taken over large parts of the country. Oil prices rose accordingly in the quarter, although not as much as had been expected. While the situation remained threatening at quarter-end, oil prices had started to edge back down. A potential spike in oil prices remains the most direct economic risk to the U.S. recovery, and, should the situation in Iraq worsen, that remains a possibility.
China also remained in the headlines, as conflicts in surrounding seas continued. Both Vietnam and the Philippines pressed claims against Chinese encroachment, even as China actually started to build islands in the disputed areas to strengthen its claims. Finally, the situation in Ukraine seemed somewhat calmer but continued to simmer.
Strong market should not breed complacency
The strong results from equity markets over the quarter have been encouraging. Investors have rightly cheered their gains and, at least in the U.S., have also benefited from a strengthening recovery. But the time for caution is just when things look best. Market volatility has declined to very low levels, which historically has signaled storms ahead. The international scene remains turbulent, especially in the oil-producing states of the Middle East, and the potential for disruption there remains.
Although we see no signs of immediate concern, we are aware that the current positive conditions are very likely to change at some point, with a consequent negative reaction in the financial markets. This is certainly worrying, but such a correction would be normal in the greater scheme of things. We remain confident in the U.S. economy and in our excellent positioning in the world, as well as in the strength of our financial markets. We believe that a well-diversified portfolio, rebalanced regularly, is still the best way to meet financial goals over time and should be maintained through good times and bad.
All information according to Bloomberg, unless stated otherwise.
Disclosure: Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets. All indices are unmanaged and investors cannot invest directly into an index. The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. The Nasdaq Composite Index measures the performance of all issues listed in the Nasdaq Stock Market, except for rights, warrants, units, and convertible debentures. The Dow Jones Industrial Average is a price-weighted average of 30 actively traded blue-chip stocks. The MSCI EAFE Index is a float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI Emerging Markets Index is a market capitalization-weighted index composed of companies representative of the market structure of 26 emerging market countries in Europe, Latin America, and the Pacific Basin. It excludes closed markets and those shares in otherwise free markets that are not purchasable by foreigners. The Barclays Capital Aggregate Bond Index is an unmanaged market value-weighted index representing securities that are SEC-registered, taxable, and dollar-denominated. It covers the U.S. investment-grade fixed-rate bond market, with index components for a combination of the Barclays Capital government and corporate securities, mortgage-backed pass-through securities, and asset-backed securities.
Joe Smalley is a financial advisor located at 213 E. Saint Joseph Street, Lansing, Michigan 48933. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. He can be reached at 517-487-4850 or at smalleyinvestments.com.
Authored by Brad McMillan, vice president, chief investment officer, at Commonwealth Financial Network.
© 2014 Commonwealth Financial Network®