2014 3rd Quarter Outlook

Review of Second Quarter

Stock values grew at a relatively steady pace for the past three months – the S&P 500 has now provided positive returns for five successive months and six successive quarters. Below are the historical returns for the major markets.

For the 2nd quarter, U.S. large company stocks increased in value by 5% and small company stocks went up by 2%. Developed market stocks also did well, increasing by 4% for the quarter. After lagging the other equity markets for the past year, emerging market stocks had a great recovery, increasing in value by 7%. Bonds increased by 2% -- the bond market has now recovered from the decline in early 2013.

It’s useful to observe that ten year-returns for U.S. stocks are now approaching their long-term averages, despite the 40% decline in late 2008/early 2009. This means that investors who did not panic during the decline have been rewarded for their patience.

Economic Outlook

The reason the equity markets have done so well is because the economy has continued to enjoy slow and steady growth. Nearly all of the economic indicators are positive. In particular, the unemployment rate has now fallen to 6.1%. We remain optimistic about the economy going forward.

No economic growth period lasts forever, and unpredictable events that can slow growth or cause a recession can occur at any time. The only foreseeable danger sign ahead is the economic reaction to the end of the bond buying program by the Federal Reserve Board. Since the program itself was unprecedented, the end of the program might have some unintended adverse consequences.

Stock Market Outlook

Because our economic outlook is positive, we believe the current level of prices in the U.S. stock market is justified. The various market rations such as stock-price-to-earnings, price-to-cash-flow, and market-value-to-book-value are at or near their long-term averages. Consequently, we think historically average long-term stock returns of 10%-11% per year can be expected over the next several years. Of course, some years returns will be much higher and some years they will be lower, but there is no reason to predict there will be abnormally high or abnormally low returns. Our belief is that now that the European economy has stabilized somewhat, we will see similar returns for developed market stocks. As for emerging markets, we feel that they will continue to provide higher returns than U.S. stocks, but with higher volatility.

The "Due" Myth

There is much talk in the financial press that the market is “due” to have a 10% correction in the market, mainly because we have not had such a correction since 2011. It is very likely that we will experience such a decline sometime in the next five years, because stock markets are volatile, and in most (but not all) five year periods, there is some time in which the market fell by at least 10%. But there is no due theory of market movements – it’s not like the mail, when if you haven’t received it by 3:00, the postman is due to show up in the next couple of hours. Markets don’t work in precise cycles – just because we haven’t had a correction in a few years does not mean one is imminent in the next few months. A correction is as likely to happen four years from now (perhaps after the market has risen by 50%) as it is to happen in the next few months. Market prices are based on expectations –if everyone truly believed a correction was going to happen in the next few months, it would have already happened. Consequently, the potential for a correction should not influence your investment strategy.

Bond Market

Our outlook on bonds hasn’t changed from the last quarter. We still believe that the end of the tapering program will cause rates on short and intermediate Treasury securities to rise over the next couple of years. We feel the prudent investment strategy is to hold a mixture of short and intermediate term maturities, and to diversify into sectors other than government bonds.

Summary

The economy is stable, and stocks are appropriately priced. Bonds have less risk than they had in early 2013, but it is likely they will provide low returns over the next few years. The economy has stabilized in Europe, and emerging markets have started to recover well from 2013. Three months ago our biggest concern was the political tension in the Ukraine. That attention has shifted back to the Middle East, with Syria and Iraq become potential problem areas. Our belief is that broad diversification across equities in various economic regions and varying types of bonds is a prudent investment strategy.

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