Our Perspective on the Market Rally


Notwithstanding the market volatility and correction which were evident yesterday, you have likely observed that equity “bulls” are excited about the markets’ present positive run. The Dow Jones Industrial Average and the S&P 500 index have each reached record highs so far this year, and European shares (as measured by the Stoxx Europe 600 index) have reached their highest levels in almost five years.

In spite of this rally, we continue to recommend to our investors to stay the course, and not let the emotion of this positive momentum sway them into adjusting their respective risk appetites. Most of us are enjoying the rally and benefit it has provided to our portfolios. However, we maintain that this calls for us to continue the discipline of a portfolio management system that separates the capital you need in the next 1 – 7 years from the inevitable volatility and downturn. We also continue to recommend that you take profits and re-deploy your gains to asset classes that have under-performed on a consistent and periodic basis (i.e. strategic re-balancing). As a reminder, the 2008 downturn is an appropriate barometer for most people, as portfolios with significant exposure to the equity markets were down 40-50%. If you remained invested, your portfolio is now (~5 years later), back above where it was. We try to identify how our clients will respond to such volatility, and then re-visit periodically to see if our assessment matches up with how clients actually reacted during the inevitable downturn.

We have spoken to clients about how we stay up to date with what is going on in the financial markets. We find it helpful to stay above the fray of the daily attention seeking newspaper and hourly television news programs (i.e. 24 hour business and world news groups). These groups seem to be clearly more focused on “grabbing eyeballs” with a controversial headline or story than in reporting facts. They ostensibly don’t find the time to check their facts, as they often seem to “re-broadcast” what they see in other dailies and hourly programs. A quick flip back to some of our past (even recent) newsletters on Cyprus, the Fiscal Cliff, and June 2012’s perspective on bond anomalies provides a healthy hindsight review of this dynamic.

One of my roles when I was called back to active duty to serve on the Special Staff for the Commanding General of the Iraqi Theater (General George Casey) in 2004 was to monitor the media. Through this experience, I developed my perspective on the daily (and hourly) popular media, as I observed errors and a lack of fact checking time and time again. Given that all military and civilian organizations reported to General Casey through me, I was in a position to know that what was being reported was frequently inaccurate, and oftentimes a simple re-broadcast of what their competitor was reporting.

To keep up with the markets and world events for my job back home as an Investment Advisor for JPMorgan, I continued to read The Economist, a weekly publication, throughout my deployment (2004-2005). That period was historic in that it included the first Iraqi election and a US election. I found the weekly publications to be much more accurate, and The Economist’s reporting was surprisingly close to what my sources were reporting to the Commanding General. Weekly publications (versus hourly or daily) seem to have more time to check their facts and provide reports that are more highly correlated with reality. To this day, I consistently read this weekly publication, which is where I gathered most of the facts for this perspective on the current equity market rally:

So what is fuelling the rally? It does not seem to be the strength of the global economy. Recent data has been mixed. Last month the International Monetary Fund (IMF) lowered its global-growth forecast for the year from 3.5% to 3.3%. If global growth prospects were improving, one would expect emerging-market stock markets to be performing well, too; in fact, they have been flat this year. And commodity prices usually strengthen when the economy improves, but The Economist’s all-items index has fallen by 3.2% so far this year, with industrial materials dropping by 7.1%.

Nor does the rally seem to be due to a surge in profits. First-quarter results from firms in the S&P 500 were better than expected, but they usually are (thanks to careful management of expectations) and they still showed only a 5.1% increase in profits compared with the same period of 2012. If financial companies are excluded, the gain was just 2.6%. In Europe first-quarter earnings were 3% lower than they were a year ago, or 7.3% if financial firms are left out, according to Morgan Stanley.

Perhaps the most popular explanation relates to the commitment of the Bank of Japan (BOJ) to eliminate deflation with the help of a big increase in the monetary base. The bank’s actions have encouraged hopes that Japan’s economy might emerge from its doldrums. Government data released on May 16th showed that Japan’s GDP rose by 0.9% in the first quarter, an annualized growth of 3.5%. The Tokyo market has been the best performer among wealthy countries this year, in local-currency terms, with the Topix 500 index up by 46% so far and by 68% over the past 12 months.

The actions of the BOJ are the latest example of an asset-buying program by a central bank. Such programs push down bond yields and encourage investors to buy risky assets. But Hans Lorenzen of Citigroup, another bank, says the programs also reduce the total supply of assets that private investors can buy. He estimates that the natural growth in the outstanding volume of financial securities has been reduced by several trillion dollars a year, which has pushed prices higher.

American inflation expectations in the bond market, as measured by the gap between the yields on conventional and inflation-linked bonds, have fallen from 2.64% last September to 2.33%. Cheaper commodities also act much like a tax cut for consumers in the rich world and can boost demand for other goods. Judging by the latest retail-sales data, consumption has held up well in the U.S., despite the recent fiscal tightening.

In contrast, the cyclically adjusted price-earnings ratio of the U.S. stock market, which averages profits over ten years, is currently 23.2, as calculated by Robert Shiller of Yale University. That valuation is well above the historical average, suggesting lower, not higher, equity returns from here.

Equities may perform much better than government bonds, but that may be because those bonds are providing dreadful returns. Another possibility is that profits can advance even further—in the U.S., they are at their highest proportion of GDP since the second world war. Commodity-price falls and stabilized wages have relieved company cost pressures. But some of the strength of American profits has come from overseas sales. In particular, a 17.8% fall in the trade-weighted dollar between March 2009 and July 2011 boosted the value of foreign profits. The dollar has since stabilized on a trade-weighted basis, and with global trade expected to grow only slowly, the boost from foreign profits may be dissipating.

While we do our best to remain abreast of what is going on in the markets, the above analysis shows how mixed the signals can be. These insights sometimes help us to develop our strategic shifts over time (i.e. we generally believe that most portfolio growth will come from outside the U.S. in the years ahead). That said, we continue to find no credible evidence that it is possible to consistently “time” getting into (and out of) markets or asset classes. We believe the key to generating returns is to avoid having to sell when the markets are down – this is the benefit of a multiple portfolio approach. The better one can forecast short- and medium-term needs and goals, the less likely one will have to sell the market-invested funds in a long-term portfolio when the markets are “down.” This has served our clients extraordinarily well during the Great Recession of 2008 and the subsequent years. We look forward to continuing our dialogue with you on the markets and other important financial planning opportunities, and to providing our clients and community with an independent perspective on events as they unfold.