What's Going on in the Markets September 9 2016

On Friday September 9 2016, the S&P 500 index fell 2.4%, while the Dow Jones Industrial Average fell 2.1%.  This was the first "greater than 1%" sell-off since June, its worst single-session loss in more than two months. The drop ended a relatively quiet summer for U.S. stocks, which had touched new highs in mid-August. But despite Friday's jarring downdraft, market internals remain solid and equity markets are within stones throw of their recent peaks. Of course, the press reports are describing it as a full-blown market panic.

Even if the short-term pullback in stocks persists, we do not believe the longer-term bull market—which has been underway since 2009—is dead. U.S. economic data has generally shown signs of strength, and an improving economy should support the stock market over the long term.

So what’s going on?  Efforts to trace the reason why quick-twitch traders scattered for the hills on Friday turned up two suspects.  The first was Boston Federal Reserve President Eric Rosengren, who sits at the table of Fed policy makers who decide when (and how much) to raise the Federal Funds rate.  On Friday, he announced that there was a “reasonable case” for raising interest rates in the U.S. economy.  According to a number of observers, traders had previously believed there was a 12% chance of a September rate hike by the Fed; now, they think there’s a 24% chance that the rates will go up after the Fed’s September 21-22 meeting. Oh the horror of a less than 1 in 4 chance of a quarter-point (0.25%) rise in short-term interest rates--sell everything!

If the Fed decides the economy is healthy enough to sustain another rise in interest rates—from rates that are still at historic lows—why would that be bad for stocks?  Any rise in bond rates would make bond investments more attractive compared with stocks, and therefore might entice some investors to sell stocks and buy bonds.  However, with dividends from the S&P 500 stocks averaging 2.09%, compared with a 1.67% yield from 10-year Treasury bonds, this might not be a money-making trade.

If the possibility of a 0.25% rise in short-term interest rates doesn’t send you into a panic, maybe a pronouncement by bond guru Jeffrey Gundlach, of DoubleLine Capital Management, will make you quiver.  Gundlach’s exact words, which are said to have helped send Friday’s markets into a tailspin, were: “Interest rates have bottomed.  They may not rise in the near term as I’ve talked about for years.  But I think it’s the beginning of something, and you’re supposed to be defensive.” My thoughts on this: pundits have been declaring the end of the bull market in bonds for many years and have been proven wrong time and time again. Statements like this are pretty worthless in my opinion. Could he be right? Sure, there's a 50/50 chance.

Short-term traders appear to have decided that Gundlach was telling them to retreat to the sidelines, and some have speculated that a small exodus caused automatic program trading—that is, money management algorithms that are programmed to sell stocks whenever they sense that there are others selling.  After the computers had taken the market down by 1%, human investors noticed and began selling as well.

Uncertainty about central bank policy outside the U.S. was another potential cause for Friday’s volatility. On Thursday, the European Central Bank opted for no new easing moves and Japanese bond yields have continued to rise. The two events have sent a message to markets that quantitative easing (bond buying and other monetary stimulus) may have lost some of its efficacy and will not continue indefinitely.

For seasoned investors, a 2% drop after a very long market calm simply means a return to normal volatility.  This is generally good news for investors, because volatility has historically provided more upside than downside, and because these occasional downdrafts provide a chance to add to your stock holdings at bargain prices. I've been telling clients all summer long to expect a volatile and rocky September and October. Does that make me smart? Nope, historically, periods of calm like we've seen are always followed by volatility. September and October tend to be more volatile than other months of the year.  Markets have been unusually calm this summer, and prolonged periods of low volatility can make markets susceptible to news and rumors. Given the emphasis the market is now placing on Fed policy—and the uncertainty surrounding it—we wouldn’t be surprised to see markets continue to experience volatile swings when news or economic data suggest the Fed may, or may not, raise interest rates.

That doesn’t, of course, mean that we know what will happen when the exchanges open back up on Monday, or whether the trend will be up or down next week or for the remainder of the month.  Nor do we know whether the Fed will raise rates in late September, or how THAT will affect the market.

As for bonds, while rising interest rates can translate into falling bond prices—bond yields typically move inversely to bond prices—it’s important to remember that yields generally don’t move in tandem all along the yield curve. The Fed influences short-term interest rates, but long-term interest rates are generally affected by other factors, such as economic growth and inflation expectations. And even if the Fed does raise short-term interest rates again this year, I would anticipate that future rate hikes would be gradual, as inflation remains low and the U.S. economy is only growing moderately.

That said, periods of market volatility are a good time to review your risk tolerance and make sure your portfolio is aligned with your time horizon and investing goals. A well-diversified portfolio, with a mix of stocks, bonds and cash allocated appropriately based on your goals and risk tolerance, can help you weather periods of market turbulence.

All we can say with certainty is that there have been quite a number of temporary panics during the bull market that started in March 2009, and selling out at any of them would have been a mistake.  You must resist overreacting to swings in the market. Stock market fluctuations are a normal part of investing; panicking and pulling money out of the market may mean missing out on a potential rebound.

The U.S. economy is showing no sign of collapse, job creation is stable and a rise in interest rates from near-negative levels would probably be good for long-term economic growth.  The Institute for Supply Management survey for the manufacturing sector recently showed an unexpected decline, and the service sector moved down by more than economists had expected, so I will be monitoring upcoming survey results closely to see if this develops into a trend. The employment situation remains firm; new job openings hit a record high in July and new claims for unemployment remain near recent lows.

While it may be prudent to trim some profits, panic is seldom a good recipe for making money in the markets, and our best guess is that Friday will prove to have been no exception. Market volatility is unnerving, but it’s a normal—and normally short-lived—part of investing. If you’ve built a solid financial plan and a well-diversified portfolio, it’s best to ignore the noise and focus on your long-term goals.

If you would like to review your current investment portfolio or discuss any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch. We start with a specific assessment of your personal situation. There is no rush and no cookie-cutter approach. Each client is different, and so is your financial plan and investment objectives.

Sources:

http://www.bloomberg.com/news/articles/2016-09-08/gundlach-says-it-s-time-to-get-defensive-as-rates-may-rise

http://www.forbes.com/sites/laurengensler/2016/09/09/stocks-fall-worst-day-since-brexit/#3a9ed7252961

http://www.bloomberg.com/news/articles/2016-09-09/split-among-fed-officials-leaves-september-rate-outlook-murky?utm_content=markets&utm

http://thereformedbroker.com/2016/09/09/dow-decline-signals-end-of-western-civilization/?utm

https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield

The MoneyGeek thanks guest writer Bob Veres for his contribution to this post

Second Quarter 2016 YDFS Market Review

The official start of summer was only a few days ago, but the market already feels like it's taken us on a wild roller coaster ride this year. It certainly makes us feel like we’re in a bear (sideways to down) market, what with the surprising “Brexit” vote in the UK, the dismal first few weeks of the year and increased volatility across the board.  So it may come as a surprise that the second quarter of 2016 eked out small positive returns for many of the U.S. market indices, and most of them are showing positive (though hardly exciting) gains over the first half of the year.

The Wilshire 5000 Total Market Index--the broadest measure of U.S. stocks and bonds—was up 2.84% for the quarter, and is now up 3.69% for the first half of the year.  The comparable Russell 3000 index gained 1.52% for the quarter and is up 2.20% so far this year.

The Wilshire U.S. Large Cap index gained 2.65% in the second quarter of 2016, putting it at a positive 3.94% since the beginning of January.  The Russell 1000 large-cap index provided a 1.44% return over the past quarter, with a gain of 2.34% so far this year, while the widely-quoted S&P 500 index of large company stocks posted a gain of 1.90% in the second quarter, and is up 2.69% for the first half of 2016.

The Wilshire U.S. Mid-Cap index gained 4.33% for the quarter, and is sitting on a positive gain of 6.67% for the year.  The Russell Midcap Index is up 1.54% for the quarter, and is sitting on a positive gain of 3.82% for the year.

Small company stocks, as measured by the Wilshire U.S. Small-Cap index, gave investors a 4.09% return during the second quarter, up 4.98% so far this year.  The comparable Russell 2000 Small-Cap Index gained 1.96%, erasing gains in the first quarter and posting a 0.41% gain so far this year, while the technology-heavy Nasdaq Composite Index lost 0.56% for the quarter and is down 3.29% for the first half of 2016.

When you look at the global markets, you realize that the U.S. has been a haven of stability in a very messy world.  The broad-based EAFE index of companies in developed foreign economies lost 2.64% in dollar terms in the first quarter of the year, and is now down 6.28% for the first half of the year.  In aggregate, European Union stocks lost 7.60% in the first half of 2016.  Emerging markets stocks of less developed countries, as represented by the EAFE EM index, lost 0.32% for the quarter, but are sitting on gains of 5.03% for the year so far.

Looking over the other investment categories, real estate investments, as measured by the Wilshire U.S. REIT index, was up 5.60% for the second quarter, with a gain of 11.09% for the year.  Commodities, as measured by the S&P GSCI index, gained 12.67% of their value in the second quarter, giving the index a 9.86% gain for the year so far.  The biggest mover, unsurprisingly, is Brent Crude Oil, which has risen more than 15% in price over the quarter.

Meanwhile, interest rates have stayed low, once again confounding prognosticators who have been expecting significant rate rises for more than half a decade now.  The Bloomberg U.S. Corporate Bond Index is yielding 2.88%, while the Bloomberg U.S. Treasury Bond Index is yielding 1.11%.  Treasury yields are stuck near the bottom of historical rates; 3-month notes yielded 0.26% at the end of the quarter, while 12-month bonds were yielding just 0.43%.  Go out to ten years, and you can get a 1.47% annual coupon yield.  Low?  Compared with rates abroad, these yields are positively generous.  If you’re buying the German Bund 10-year government securities, you’re receiving a guaranteed -0.13% yield (yes, that's a negative yield).  The 5-year yield is actually worse: -0.57%.  Japanese government bonds are also yielding -0.3% (2-year) to -0.23% (10-year). Can you imagine paying someone to hold your money for you?

On the first day of July, the Dow, S&P 500 and Nasdaq indices were all higher than they were before the Brexit vote took investors by surprise, which suggests that, yet again, the people who let panic make their decisions, lost money while those who kept their heads in it, sailed through.  There will be plenty of other opportunities for panic in a future where terrorism, a continuing mess in the Middle East, a refugee crisis in Europe and premature announcements of the demise of the European Union will deflect attention away from what is actually a decent economic story in the U.S.

How decent?  The American economy is on track to grow at a 2.0% rate this year, which is hardly dramatic, but it is sustainable and not likely to overheat different sectors and lead to a recession.  Manufacturing activity is expected to grow 2.6% for the year based on the numbers so far, and the unemployment rate has fallen to 4.7%, which is actually below the Federal Reserve target.  Inflation is also low: running around 1.4% this year.  The unemployment statistics are almost certainly misleading in the sense that many people are underemployed, and a sizable number of working-age men are no longer participating in the labor force, but for many Americans, there’s work if you want it.  Historically low oil prices and high domestic production have lowered the cost of doing business and the cost of living across the American economic landscape.

Despite all this good news, the market is struggling to keep its head above water this year, and is not threatening the record highs set in May of last year. But we're close, and I suspect that we will challenge and rally above the old highs soon.

Questions remain.  The biggest one in many peoples’ minds is: WILL the European Union break up now that its second-largest economy has voted to exit?  There is already renewed talk of a Grexit, along with clever names like the dePartugal, the Czechout, the Big Finnish and even discussion about Texas (Texit?) leaving the U.S.  How long before we hear about (cue the sarcasm) some localities declaring independence from their states?  With active political movements in at least a dozen Eurozone countries agitating for an exit, is it possible that someday we’ll view the UK as the first domino?

A recent report by Thomas Friedman of Geopolitical Futures suggests that the EU, at the very least, is going to have to reform itself, and the vote in Britain could be the wake-up call it needs to make structural changes.  The Eurozone has been struggling economically since the common currency was adopted.  It is still dealing with the Greek sovereign debt crisis, a potential banking crisis in Italy, economic troubles in Finland, political issues in Poland and, in general, a huge wealth disparity between its northern and southern members.  Is it possible that a flood of regulations coming out of Brussels is imposing an added burden on European economies?  Should different nations be allowed to manage their policies and economies with greater independence and focus?

Friedman thinks the UK will be just fine, because Europe needs it to be a strong trading partner.  Britain is Germany’s third-largest export market and France’s fifth largest.  Would it be wise for those countries to stop selling to Britain or impose tariffs on British exports?  And more broadly, with the political turmoil in the UK, is it possible that there will be a re-vote, particularly if the European Union decides to make reforms that result in a less-stifling regulatory regime?

You’ll continue to see dire headlines, if not about Brexit or the Middle East, then about China’s debt situation and the Fed either deciding or not deciding to raise rates in the U.S. economy (it won't).  Oil prices are going to bounce around unpredictably.  The remarkable thing to notice is that with all the wild headlines we’ve experienced so far, plus the worst start to the year in U.S. market history, the markets are up slightly here in the U.S., and the economy is still growing.  The chances of a U.S. recession starting in the next nine months are 10% or less.  Yes, your international investments are down right now, but eventually, you can expect them to come to the rescue when the American bull market finally turns.

When will that be?  If we knew how to see the future for certain, we would be in a different business.  All of us are going to have to resign ourselves to being surprised by whatever the rest of the year brings us, headline by headline. That, however, doesn't stop me from making my own prognostication about what the market might bring.  By the end of the year, I think we'll see mid-single digit gains for the year, after some hand-wringing over the election, in what I expect to be a rough September and October in the markets. But then again, I thought the Brexit would be voted down, so don't bet your chips on any predictions anyone has, including me. This keeps us mostly invested with good hedges to absorb whatever volatility the market throws at us.

Sources:

Wilshire index data.  http://www.wilshire.com/Indexes/calculator/

Russell index data: http://indexcalculator.russell.com/

S&P index data: http://www.standardandpoors.com/indices/sp-500/en/us/?indexId=spusa-500-usduf--p-us-l--

Nasdaq index data: http://quicktake.morningstar.com/Index/IndexCharts.aspx?Symbol=COMP

International indices: http://www.mscibarra.com/products/indices/international_equity_indices/performance.html

Commodities index data: http://us.spindices.com/index-family/commodities/sp-gsci

Treasury market rates: http://www.bloomberg.com/markets/rates-bonds/government-bonds/us/

Aggregate corporate bond rates: https://indices.barcap.com/show?url=Benchmark_Indices/Aggregate/Bond_Indices

Aggregate corporate bond rates: http://www.bloomberg.com/markets/rates-bonds/corporate-bonds/

http://useconomy.about.com/od/criticalssues/a/US-Economic-Outlook.htm

http://www.marketwatch.com/story/first-quarter-us-gdp-raised-to-11-2016-06-28?siteid=bulletrss

The MoneyGeek thanks guest writer Bob Veres for his contribution to this post

Recovery—For How Long?

On Tuesday of this week, the U.S. stock markets (S&P 500 index) went up 2.39%, the highest one-day return in a month. Analysts attributed the rise to a variety of economic news that suggested that the American economy is not, after all, plunging into recession. The buoyant mood among investors may not last, but for many, it’s a welcome sign that things may not be as gloomy as they seemed just a month ago.

In fact, the S&P 500 only dropped about 12%, from 2078.36 at the end of December 2015 to the bottom of 1829.08 on February 11—despite widespread predictions of a 20% bear market. Since then, it has risen on shaky legs back to more than 1999, just 79 points from breaking even on the year. One more day like Tuesday would erase nearly all of the damage in 2016.

The good economic news involved construction spending, which reached its highest level since 2007. Oil prices were also gaining ground, although it’s hard to see why the average American would find reason to cheer about that. In addition, new orders and inventories stabilized in the manufacturing sector, after experiencing downturns in the last quarter of 2015.  On Friday, The February jobs report showed that the economy created 242,000 jobs and unemployment remains at a low 4.9%.  Other factors include the possibility that U.S. stock investors may finally have decided that declines in the Chinese markets are not going to directly affect the value of American-based businesses.

None of this means that we know what will happen next. Neither we nor any of the pundits you see on the financial news have any idea whether that long-awaited 20% decline will materialize, or the markets will continue to recover and we’ll all look back on February 11 prices as a great time to buy. But it’s worth reflecting on how unexpected this latest rally has been at a time when it seemed that all the news pointed to more pain and decline. Anybody who believed the pundits and fully retreated to the sidelines after the January selloff is now sitting on losses and wondering whether to jump in now and hope the gains continue, or wait and hope for another downturn, and risk losing even more ground if this turns out to be a long-term rally. This is not to say that hedging or taking some bull market profits off the table is still not a good idea. All-or-nothing investing is almost never a good idea.

We can never see the next turn in the market roller coaster, but long-term, the markets seem to operate under the opposite of the pull of gravity. You and I know with some degree of certainty in which direction the next 100% market move will be, even if we can’t pinpoint when or where.

Sources:

http://www.businessinsider.com/the-stock-market-is-over-china-2016-2

http://www.bloomberg.com/news/articles/2016-02-29/japan-futures-down-on-strong-yen-as-china-stimulus-buoys-aussie

http://finance.yahoo.com/news/wall-st-open-higher-oil-143344528.html

The MoneyGeek thanks guest writer Bob Veres for his contribution to this post