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Investment Letter

2nd Quarter 2014

The score at the half of this financial year still has the home team ahead despite a bumpy start to 2014.  The first negative growth rate for a quarter in three years and the lackluster financial market performance during the first quarter had many of us worried, but the financial markets rediscovered much of its lost momentum during the second quarter to finish the first half of 2014 on a positive note.  Of course the final outcome has yet to be decided, but it certainly looks like the second half of 2014 will remain favorable for investors.

The Dow Jones Industrial Average (DJIA) rose 368.94 points to finish the quarter at 16,826.60 points.  After an uneventful first quarter, the DJIA posted 11 record highs during the second quarter to boost the total return of the index to 2.68% at the 2014 midpoint.  The S&P 500 Index fared even better during the first half of the year and posted a total return of 7.14%.  After 21 new record highs during the first six months of 2014, the index settled at 1,960.23 points.  Real estate continued its outstanding performance with a total return of 7.15% for the second quarter and an 18.24% return through 6/30/2014.  The bond market also rallied during the first six months of 2014 as prices moved higher and the yield curve flattened out.  In particular, longer-term bond yields on the 10-year Treasury Note fell from 3.00% at the start of 2014 to 2.53% through the end of June.

The chart below recaps the 2nd Quarter and year-to-date performance of other major indices:

 
 

Asset Class

Index

2nd Qtr. 2014 Total Return

2014 Total Return

Cash

ML Three-Month U.S. Treasury

0.01%

0.02%

U.S. Bonds

Barclays Intermediate-Term Treasury

0.92%

1.57%

U.S. Large Co. Stocks

S&P 500

5.23%

7.14%

U.S. Small Co. Stocks

Russell 2000

2.05%

3.19%

International Stocks

MSCI EAFE (net div.)

4.09%

4.78%

Real Estate

DJ Select Real Estate Securities

7.15%

18.24%

 
 Source: Morningstar
 
 
The -2.9% contraction in economic growth for the first quarter was an unexpected surprise, but recent data confirms the fundamentals are still strong.  Corporate balance sheets remain healthy and profit margins are up; vehicle sales are increasing; manufacturing and trade inventories are rising in anticipation of stronger demand; corporate investment is rebounding; the unemployment rate is down to the 50-year average of 6.1%; inflation remains low; and consumer confidence is at its highest level since January 2008.  Based on the data above, the second half of 2014 has growth potential.  Unfortunately, housing activity across much of the country continues to be a drag on the economy as mortgage applications, home sales, and housing starts are behind last year’s pace.   

The Federal Reserve’s monetary policy remains accommodative, but they are shifting toward policy normalization.  At the June meeting, the Federal Open Market Committee (FOMC) indicated they will reduce the quantitative easing program by slowing the monthly bond purchases from $45 billion to $35 billion.  The FOMC also stated that they will reinvest the proceeds of maturing securities, maintain the current range for the federal funds rate, and monitor incoming data over the coming months and adjust policy accordingly.

Our outlook for the rest of 2014 remains positive.  We believe that the rebound in growth during the quarter will continue during the second half of 2014.  We believe there is sufficient slack in the economy to feed the expansion, and the financial markets should benefit from this favorable environment.  The Fed will maintain their policy to promote economic growth and stability, and all indications lead us to believe that it will be next year before they are ready to start raising the federal funds rate.  Therefore, we anticipate more of the same…a slow and steady pace to the economic expansion.

While we still believe that many of the obvious risks to our economic prosperity have diminished, the recent escalation of violence in the Middle East is a growing and serious threat to the stability of the global oil markets.  Consequently, oil and gas prices spiked during the quarter as fears of a supply disruption increased.  

Another variable we are closely tracking is the rising food costs due to the droughts in California and the pork/beef/poultry shortages.  Household budgets are already being negatively affected as rising costs are passed on to consumers.  The resulting decrease in consumer discretionary spending will have an unfortunate impact on Gross Domestic Product (GDP) if conditions linger.  A rapid rise in inflation due to the increases in food and energy prices is an added concern we have for the economy.  While inflation has been low for a long time, the threat of a spike is very real. 

The buzz about a market correction has grown louder despite the positive economic news.  There are always pundits readily available to declare the sky is falling, but we are concerned because the conversation is spreading and becoming more prevalent with the main stream media.  As the quarter ended, the correction-free (10% drop) run for the S&P 500 index surpassed the 1,000 day milestone.  This is the 5thlongest stretch without a double digit pullback in the last 50 years.[1]  We do not believe that a significant correction is imminent, but we do think the probability of a correction has increased and the risk continues to grow as time passes.  It is important to remember that perceptions and fears of a market correction often influence investors to sell in a panic even when the economic indicators point upward. 

Last, but certainly not least, we believe the further intensification of geopolitical turmoil is another variable that could severely impact the domestic economic expansion and international economic recovery. 

As I have often stated, our investment philosophy remains based on the fundamentals.  The day-to-day price volatility of the stock market is unavoidable and can be deeply influenced by domestic and international variables.  Investors need to manage their expectations of the stock market accordingly.  We believe that it is time---not timing---that matters most.  That is why we believe the successful long-term investor is patient, weathers market swings, and adheres to a disciplined investment process that includes a diversified asset allocation strategy based upon a tolerance for risk and need for return.  In other words: Don’t use your emotions to make investment decisions; separate your money from your moods.

Improving portfolio returns by avoiding periods of poor performance is an appealing proposition for investors, but successfully timing the stock market is close to impossible.  Investors who attempt to time the market run the risk of missing periods of exceptional returns, which leads to adverse effects on the ending value of a portfolio.

Take a look at the following example of market timing: During the period of 1994-2013, an investor who stayed in the market (S&P 500 index) for all 5,040 trading days achieved a compound annual return of 9.2%.  However, that same investment would have returned 5.5% had it missed only the 10 best days of stock returns.  Additionally, missing the 50 best days would have produced a loss of 2.8%.[2]  The table below helps illustrate the benefits of being a patient long-term investor.

 

S&P 500 Index Peaks and Troughs

Low

High

% Change

Dec. 31 1996

741

Mar. 24, 2000

1,527

106%

Oct. 9, 2002

777

Oct. 9, 2007

1,565

101%

Mar 9. 2009

677

Jun. 30, 2014

1,960

190%

                     Source: J.P. Morgan Asset Management

Beginning December 31, 1996, the stock market (S&P 500 index) has experienced three distinct peaks and troughs.  It is unclear how much higher the current stock market will climb, but history shows that if an investor is willing to show patience and stay the course during the recovery process, the reward can be significant.

In closing, I want to thank you for the opportunity of working with you and for your continued confidence and trust. 

Please contact me if you have any questions. 

With kindest personal regards, I am

Very truly yours,

WILLIAM HOWARD & CO. FINANCIAL ADVISORS, INC.

 
  
[1]Source: By the Numbers Research, 06/30/2014, Avoiding a Correction.
 
[2]Principia® Presentation and Education, 2013 Principals of Investing Module, The Cost of Market TimingRisk of missing the best days in the market 1994–2013.@import 

 

 

 

 

 

 
 
 
 
 

 

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