2014 2nd Quarter Outlook

It was an eventful three months for stocks, although in the end, the overall movements in equity markets were modest. Below are the historical returns for the major markets:

U.S. large company stocks increased in value by 2% and small company stocks went up by 1%. However, the relatively small increases belie the more dramatic monthly movements. For the first month, the S&P 500 declined by almost 6% before recovering nicely over the next two months. Developed market stocks followed a similar trend, increasing by 1% for the quarter. Emerging market stocks fell by less than half a percent, hampered by the problems involving the Ukraine. The bond market increased in value for the quarter by 2%, and investors have seemed to accept the tapering of the bond buying program by the Federal Reserve.

Economic Outlook

As was the case at the beginning of the year, the current economic data is very positive. Some of the many positive signs include:

• Gross Domestic Product (GDP) growth for 2013 was 2.6%

• The unemployment rate has leveled at 6.5%

• Inflation remains low – the consumer price index has risen by 1.5% over the past year

• U.S. corporations and households continue to reduce the amount of borrowing

• Corporate profits, in absolute terms, and as a proportion of sales, continue to set record levels

• Real estate prices continue to recover from the recession

• Corporate capital spending, while still below pre-recession levels, continues to rise steadily

For all of these reasons, we remain bullish on the U.S. economy.

Stock Market Outlook

Before looking forward, let’s review some of our comments we made at the beginning of the year. Specifically, we chided those who were calling the current valuation of U.S. stocks a “bubble,” and predicting an imminent significant decline in prices. Obviously, such chiding was warranted. What is particularly interesting is that although the market conditions today are virtually identical to what they were in January, we see few market commentators using the “b” word. Apparently, bubble bursting predictions, like corporate earnings, follow a momentum pattern with a high degree of randomness.

While we are not as bullish on the stock market as we are on the economy, we still believe it is a good time to invest in stocks. Valuations relative to earnings are close to long-term market averages. As we suggested in January, there has been a small rise in market volatility, but it’s still much lower than historical norms.

Of course, with stock markets, short-term movements will always be difficult to predict, because we are dealing not only with changes in corporate and economic data, but also investors’ psychological reactions to that data. Our main tangible concern is the situation in the Ukraine. While there are always political tensions across the globe, one that involves a major economic and military power justifiable creates significant uncertainty.

Bond Market

The bond market seems to have stabilized. It’s interesting that with all of the commotion about the risk of bonds since April of last year, the broad bond market has been basically flat for the past 12 months. However, we remain somewhat concerned about Treasuries, and we still believe one should continue to diversify away from government bonds and into other sectors of the market, at least until the tapering program is complete.

Summary

The economic and market situation remains largely unchanged from three months ago. The economy is continuing its long slow path of recovery from the recession. The U.S. stock market is stable with appropriate valuations and good growth prospects. Our main concern is the political tension in Eastern Europe. Bonds, while an important part of most investor’s portfolios, will probably yield low returns going forward. While we believe stock market returns in the future will be lower than what investors’ enjoyed over the past few years, we feel very comfortable recommending balanced portfolios including an appropriate portion of equities.