Finance, Insights

Seven Week Itch

PaulNolte-2“A day that will live in infamy” marked the entry of the US into WWII. Over the ensuing decades, the US and Japan have  mended those wounds to such an extent that they now stand side by side as allies. Ironically, in just two weeks the big screen release of Unbroken will debut, highlighting the life of Louis Zamperini, which includes his time as a Japanese prisoner of war. What happens in the Far East still has an impact on the US, although in a very different way. Monetary policy around the globe has been very accommodating, but none like what is being seen in Japan. Total debt is nearly twice that of the size of their economy (vs. merely equal in the US). Many believe that economic growth will solve this “temporary” problem. The US seems to be a global outlier, as growth is above others and the recently released
employment report now raises worries that the US economy is “running hot” and in need of higher interest rates to thwart coming inflation. Our best guess is that the US economy cannot function in a bubble, avoiding the global slowing economies forever. While job growth is tremendous, wage growth remains below historical norms and that is the engine of future growth. The coming week is short on economic data, so investors are likely to be listening to various speeches by bankers about their views on economic growth and likely changes to monetary policy.

For the seventh consecutive week, the SP500 finished higher. With just three weeks to go in the year and December being the strongest month of the year, it is possible to see 10 weeks of increases. Once the calendar flips to the new year, there may be some reasons to worry about further gains. In addition to the very bullish stance of investors for much of the past month and historically high valuations, investors may be willing to sell and lock in gains that they won’t have to pay taxes on until 2016. A diversified portfolio of investments is supposed to provide the most consistent returns with the least amount of risk. This is as true with various asset classes as it is with individual stocks or bonds. However, it does not mean that a diversified portfolio will always match the popular benchmark of the SP500. Over the past two years the
SP500 has surpassed every other asset class, meaning any diversified portfolio has lagged the index. Over the past five years, a domestic only portfolio, consisting of REITs, SP500 and small cap stocks would have trounced a more traditional global portfolio. Similar to the 1990s, the “US-centric” portfolio topped the performance charts, only to give way to underperforming a broadly diversified portfolio during the 2000s. The financial markets may be in a similar situation today, where the SP500 is not the “king of the hill”. Having benefited from a strong dollar and perception that the US is in the best global economy, the SP50 may actually under-perform international and emerging markets in the years ahead.

It should come as little surprise that on the asset class rankings, bonds have tread near the bottom along with money market rates. What is a surprise, though, is their rate of return are in excess of the yields offered on bonds. Which means that that yields continue to decline (and prices rise). Pundits have been calling for higher rates in nearly every year in the past ten, only to be surprised at the end of the year. 2015 may be yet another good year for bonds in absolute terms, as calls for rate increases fly in the face of foreign bank rate cuts and persistently low commodity prices. The bond model has been positive in all but one week over the past 16 months. Until we begin to see persistently higher rates, we remain very open to the possibility of still lower rates ahead.

The major asset classes have not only favored the domestic markets vs. international but even commodities too. When drilling down further into the SP500 industry groups, we see relative stability over the past six months. The two dominant sectors have been health care and technology. The two worst are the more economically sensitive: energy and basic materials. There is usually a tie between the economy and industry sector performance. Utilities and financials tend to do well in bear markets; however they remain among the top groups today. Energy and gold dominate late in a bull market, but they peaked out during the summer. The current leadership hardly ever perform well together as heath care does well toward the beginning of a bear market and technology in an early bull market. It is these conflicting signals that have kept
investors guessing as to where in the economic cycle we are presently and what industry groups are likely to come to the

The markets may take a break this week, if only a relatively short pause before the final year end push higher. Investors are stuck with “Tina” – there is no alternative when looking at stocks. But even a near zero rate of return will look pretty smart when (no if) the markets start to persistently decline – whenever that begins. Bond investors continue to enjoy 4%+ annual rates of return and may continue to do so well into the New Year.

The opinions expressed in the Investment Newsletter are those of the author and are based upon information that is believed to be accurate and reliable, but are opinions and do not constitute a guarantee of present or future financial market conditions.