August Musings

“The Beat Goes On!” 

August 5, 2013 

Stocks outperformed bonds in the month of July with the S&P 500 finishing up 5% at 1685.73. 10-year Treasuries closed with a 2.58% yield after the Fed said it will continue the QE program. Bonds recovered by +0.14% but were down 2.31% in aggregate for the year. 

GDP rose 1.7% for the second quarter which was better than expected but moderate growth for a post Depression recovery. The Federal Reserve forecasts 3% GDP growth in the second half as it anticipates 6.5% unemployment and 2% inflation before ending the bond purchase program. 

It seems we are in a secular bull market in US shares as measured by the SPX index. Levels are 9% above the high of 1565 reached in 2007. Many participants do not trust stocks as after 13 sideways years and 2 bear markets. The last bull run was 1982-1999. Pension funds are underweight equities and cannot meet 7 percent targets by owning bonds. 

Conversely a bear market in bonds began July 2012 with a 1.4% nadir in the 10-year note. Since May's 10-year yield of 1.60% longer term bond prices dropped dramatically. Other high yield instruments including Utilities, REIT’s, and MLP's have under performed the broad stock market averages. We have begun to price in an end to financial repression which has kept bond yields artificially low. 

Current concerns include China's 7% and slowing GDP along with Japan’s economic experiment and the upcoming the German election. Any surprise could tilt investors back toward a more cautionary stance but most forecasters see better economic times ahead. 

Recently a perceptible change has occurred whereby most bonds no longer provide positive returns. We are focusing our investments on low or no duration bond funds which have held up relatively well but are not gaining like stocks. Any investments less than 100% SPX has been relatively disappointing. Investors who formerly avoided risk now want performance that only equity exposure can provide. 

Global markets are smarting from severe drops in commodity prices caused by China's slowdown and recession in Europe. Most Emerging markets have negative returns year to date. European stocks are just beginning to perform while America's rebound has given greater confidence to a system that held together after a period of great stress. SPX earnings have increased from 2010’s $83.66 to $102.47 last year + 22.5% yet the market has rallied about 36 % because stock market multiples are rising. 

Investors know that slow earnings growth trumps rising yields. Except for the irrational P/E peak in 1999-2000 investors have been willing to pay between 7 and 22 times earnings for the past 8 decades. According to Yardini Research SPX operating earnings are expected to be $111.00 in 2013 and $123.58 next year. The market sells at a 15.18 multiple for 2013 and 13.63 times next year's estimate. We are above the midpoint of the historic range but not overvalued. 

If the economy and corporate earnings do not hit a wall stocks become the asset of choice. With earnings rising and bonds no longer a safe bet, the stage is set for more gains. Having made the case for stocks, we recall that corrections frequently come in the Fall as Congress gets back into session. Since 1964 we have had 17 autumn declines of more than 10 % with much of the damage done in October. 

Our job is to cope with changing circumstances as best we can. We therefore adjust portfolios in a deliberate manner. It has been a challenging task to adjust rapidly enough in this slow growth and government policy driven cycle. In a rising market the only winning strategy is to move into better performing securities. Trends have changed and we are acting accordingly. As always your questions and comments are welcome. 

Doug Coppola

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