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Investment Letter

2nd Quarter 2016

July 1, 2016

 

The midpoint of the year is here and it is officially SUMMER!  Time to step back and take a break from the hustle and bustle called life.  Time to soak up the bright sun and enjoy the warm temperatures.  Time to travel, visit family and friends, and have fun!  What a great summer recipe for rest and relaxation to help us recharge for the second half of the year.

The financial markets could probably use a summer break, but rest is not an indulgence the markets enjoy.  The Dow Jones Industrial Average (DJIA) celebrated its 120th birthday on May 26, 2016.  During its long history, the DJIA passed the 1,000 point milestone 18 times.  It only took 76 years for the average to break the first 1,000 point mark in 1972, and the last milestone occurred in 2014 when it closed at 18,024.17.  The second quarter was exciting as the DJIA experienced more short-term price volatility.  On April 1, the Dow started at 17,685.09; surged above 18,000 in April; declined below the quarter beginning level in May; recovered to reach 18,011.07 on June 23; fell approximately 5% after the Brexit vote; and recuperated most of the Brexit losses during a three-day rally to end the quarter at 17,929.99.  The total return for the quarter was 2.07%, and the total year-to-date return was a respectable 4.31%.

The S&P 500 Index faced similar volatility patterns as it closed the second quarter at 2,098.86.  The total return for the quarter was 2.46%, and the year-to-date total return was 3.84%.  As a reminder, the S&P 500 Index last set a record high on May 21, 2015 when it closed at 2,130.82.  The index is very close to topping this record and officially extending the current bull market into its seventh year.

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

 

Asset Class

Index

2nd Qtr. 2016 Total Return

2016 Total Return

Cash

BofA/ML Three-Month U.S. Treasury

0.07%

0.15%

U.S. Bonds

Barclays Intermediate-Term Treasury

1.28%

3.66%

U.S. Large Co. Stocks

S&P 500

2.46%

3.84%

U.S. Small Co. Stocks

Russell 2000

3.79%

2.22%

International Stocks

MSCI EAFE (net div.)

-1.46%

-4.42%

Real Estate

DJ Select Real Estate Securities

5.42%

10.82%

                              Source: Morningstar

Data during the quarter showed improvement in the domestic economy and proved consumers remained the driving force behind economic expansion. 

Here are some of the major economic points for the 2nd Quarter:

  • Consumer spending (the largest component of GDP) continued to be strong.
  • Consumer balance sheets remained attractive.
  • Lending activity and credit conditions improved.
  • Housing activity advanced.
  • Inflation remained low.
  • Job growth increased by 287,000 in June.
  • The unemployment rate rose to 4.9%.
  • Oil prices increased slightly.
  • Manufacturing and corporate profits continued to be dragged down by the strong dollar, poor performance of the energy sector, and slowing global growth. 

According to the U.S. Department of Commerce, the first quarter revised estimate for Gross Domestic Product (GDP) increased at an annual rate of 1.1%. The increase in GDP was attributed to rising consumer spending, housing investment, state and local government expenditures and exports.[1] 

The Beige Book report released by the Federal Open Market Committee (FOMC) in June stated economic activity in April thru mid-May increased at a moderate pace.  Echoing the points above, the report stated the following: Consumer spending and tourism activity was up; Modest growth in nonfinancial services; Manufacturing activity was mixed; Real estate construction and activity generally expanded; Overall loan demand was up moderately; Crop conditions were promising; Energy sector remained weak; Employment grew modestly but labor markets remained tight.[2]

The FOMC decided to maintain the target range for the federal funds rate at 1/4 to 1/2 percent at the June meeting.  The Committee indicated conditions remained accommodative, but the pace of improvement in the labor market had slowed and inflation continued to run below long-term objectives. The disappointing jobs report in May and the uncertainty surrounding the Brexit vote contributed to the Fed’s decision to keep rates steady.  It appears the Fed is taking a Goldilocks approach (conditions have to be ideal) before policy normalization resumes.  Expectations for future increases in 2016 have diminished, and it is likely the federal funds rate will remain at the current level for some time. 

The United Kingdom (UK) referendum to exit the European Union (a.k.a. the Brexit) was the top news story during the quarter.  The voting results surprised investors when a clear majority (52%) of UK citizens voted to “Leave” on June 23rd2016.  Prior to the vote, most polling suggested a close decision, but one that would favor the “Remain” campaign.  While the fallout varied among global economies, the British pound experienced the sharp end of the market’s reaction as it fell to its lowest level since the mid 1980s.  Over the short-term, the Brexit decision will increase uncertainty in the region, destabilize European financial markets, and threaten the solidarity of the UK.  Long-term implications of the vote will depend on the exit negotiations with the European Union.  The process will not be easy, and it could take years before the issue is resolved.  Going forward, we think the UK leaders will be challenged to maintain the same level of economic influence with their European partners.

Once again, our outlook for the domestic economy remains optimistic.  We believe the current pace of growth is sustainable, and improvement in corporate profits, housing, and manufacturing could lead to a slight acceleration of growth for the remainder of 2016.  Additionally, a strong labor market should persist, oil prices are likely to stabilize further, and inflation should remain low.  The Fed has become quite dovish lately regarding future rate hikes, and we anticipate this will translate into one rate increase for the remainder of the year.  Timing of the next rate hike will be dependent on inflation indicators and global economic developments.  Our guess is this fall at the September meeting, but a lot can happen between now and then.

Unfortunately, our outlook for international economies has become more pessimistic since the Brexit vote.  Growth in the European Union is anemic, and the Brexit decision will further compound their economic recovery.  We expect increases in market volatility as member countries experience heightened levels of investor anxiety and political/economic uncertainty.

Japan’s ongoing struggle to find the right mix of monetary, fiscal, and structural policies to stimulate economic growth will continue.  China is still adapting to slower economic growth prospects.  Emerging market economies remain mixed, and low oil and commodity prices will be a strong headwind for the remainder of the year.

There are a handful of risks still in play that can derail our economic prosperity.  Fiscal and monetary policies, continued strength of the dollar relative to other currencies, oil prices, China’s growth, Brexit negotiations, and escalating geopolitical tensions are just a few that come to mind.  In particular, there is one risk that might significantly impact the domestic economy and financial markets during the second half of 2016: the U.S. Presidential election.  Now that the issue of who will be running has been sorted out, the focus should turn to each candidate’s platform.  We will be keeping a close eye on election developments, and we anticipate more details regarding policies and agendas during the national conventions in July and future debates later this year.

How does the presidential election influence the financial markets?  One of the more common beliefs called the “Presidential Election Cycle Theory” was developed based on historical observations of stock returns during and after presidential elections.  It simply states that the stock market follows a four-year pattern with each election cycle, and stock returns are usually weaker post-election and stronger pre-election for a new U.S. President.  The pattern was reliable for many years, but recent history has shown that the theory is not as accurate.   It is no secret that polices implemented by a new administration will influence the economy, but another election belief states that markets tend to react positively to the more pro-business party if they are elected.  Since 1945, historical returns show that the average gains in stocks have favored a Democratic presidential administration (9.7%) over Republican (6.7%).[3] 

What concerns us most is the uncertainty involved with this election outcome.  Financial markets don’t react well to uncertainty.  A tight race between the candidates could make investors nervous.  High anxiety likely translates to an increase in volatility as the election looms.  In spite of the potential uncertainty, the financial markets have a way of defying expectations and climbing the wall of worry.  Look to stocks later this year for a hint on who might be victorious.  The incumbent party often wins if stocks are positive in the three-months leading up to the election.  Regardless of who is elected, the economic situation our next president will inherit is much different than 2009 when President Obama first took office.

As long-term investors, we need to be cognizant to that fact that market corrections are a natural but frustrating part of the investment journey.  Reactions during periods of negative market returns can significantly impact your investment portfolio.  The illustration below represents three hypothetical investors who invested $10,000 in the market (S&P 500) at the highest point prior to the market downturn in 2008.

   Source: Selected Funds, Thomas Financial, Lipper, and Bloomberg

After the 2008 market correction, the nervous investor sold this stock portfolio and invested in cash at the S&P 500 Index low point on March 9, 2009. The nervous investor never got back into the stock market and missed out on the recovery.  That cash portfolio was worth $4,791 as of 12/31/2015.

The patient investor remained fully invested in the stock market through the downturn and recovery.  Despite investing at the high point of the market, the patient investor stayed the course and watched this investment grow to $15,617 as of 12/31/2015.

The savvy investor viewed the 2008 downturn as an opportunity to buy stocks at a discount and made an additional $10,000 investment in the S&P 500 Index on March 9, 2009.  That additional investment helped the portfolio expand to $50,508 as of 12/31/2015.

Remember, 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.  Our investment philosophy remains based on the fundamentals, and we believe that it is time---not timing---that matters most. 

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: Bureau of Economic Analysis Gross Domestic Product: First Quarter 2016 (Third Estimate), http://www.bea.gov/newsreleases/national/gdp/2016/pdf/gdp1q16_3rd.pdf

[2]Source: Federal Reserve System, Monetary Policy Beige Book Report, 1 June 2016, http://www.federalreserve.gov/monetarypolicy/beigebook/beigebook201606.htm

[3]Source: Heather Long, Democrats vs. Republicans: Who's better for stocks?, CNN Money, 28 October 2015, http://money.cnn.com/2015/10/28/investing/stock-market-democrats-republicans/

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