Year End Wrap-Up

PaulNolte-2The gift of the Fed was initially well received, however after some thought and analysis, investors hit the return window rather quickly. The first rate increase in nearly 10 years was certainly not a surprise. What may have investors on edge is the “dot plots” that are an indication of anticipated interest rates over the next few years. To satisfy the expectations, rates would increase by a quarter percent at roughly every other meeting next year. It is expected rates would continue higher toward 3% which is considered “normal” in the ensuing years. The market fell as investors worry that the Fed may have acted in haste raising rates now and that the trajectory is too aggressive. There is no pleasing Wall Street! Concerns remain regarding still falling commodity prices and the specter of serious problems within the junk bond market. In what should be a quiet trading market, there is plenty of economic data to chew on, including housing data, income figures and yet another revision to GDP. There maybe a present or two under the tree, but it is looking more like coal in the stockings!

The decline after the Fed meeting erased all the gains built up in advance of the big decision. The trends of much of the last few months remain in place: the larger the stock, the better the return. International is looking better, but still struggling to best the SP500. Within the SP500, volume has certainly picked up during the declining days, while dwindling during the advances. Also, given the strength in the largest stocks within the SP500, the net number of advancing to declining stocks is also looking rather sad. Coming into this year there were a few historical sign posts that pointed to a better than average year. First, is the calendar. For whatever reason, years that end in “5” have been up in every year since the ‘20s. The second is that years ahead of the election are also positive. The party in power tries to goose the economy, helping their election chances. Of course, the overarching problem with the market is and has been for the past three years, an overvalued market that will eventually “revert” toward historically “normal” valuations that may be anywhere between 10-20% lower.

The Fed increase in short-term rates actually had a positive impact on long-term bonds. Falling commodity prices are not new, but the promise of higher interest rates tends to dampen any potential gains. Since long-term rates tend to follow inflation levels, the prospect for lower inflation in the months/years ahead helped rally the 10 year and beyond maturities. Also, the market is beginning to realize that there has been little in the way of long-term bond issuance, especially from the government. Insurance companies are very large buyers of long-term bonds, as they invest for future promised life insurance payouts. So, a small supply and lower inflation prospects have pushed long rates back down below 3% and 2.25% on 10 year bonds. The shrinking difference between long and short term rates is now among the lowest in the past 10 years. We still expect interest rates in general to decline further as long as commodity prices remain weak.

The trading activity of the past week indicated investors are very concerned with central bank actions and commentary. From the hope of a gradual rate increase or one and done to a much steadier and higher increase has pushed some investors away from stocks. Some of the high flyers for the year are even coming under some pressure, as investors lock in some profits before year end. The major characteristics remain in place. Larger is better and growth stocks beat value stocks. Domestic is better than international. We have been expecting those dynamics to change in 2015, after being in place for much of the past 3-5 years, nevertheless the SP500 remains king of the performance “game”. Diversification, other than buying longer dated government bonds, has hurt performance. Cheap markets, like international and especially emerging markets continue to be cheap markets. What has been missing is a catalyst to get those markets to perform better. Maybe in 2016?

We got the expected large swings in stock prices last week, from early rallies to late declines. Trading activity should slow down dramatically, with the markets closed half-day on Thursday and all day on Friday. There may also be some end of the year bargain hunting to prop up the markets through year end as well. Barring any big surprises, the trend into yearend may be modestly and quietly higher. Bond investors can sit tight as rates are not likely to move higher 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.