Equities continued to go up in the second quarter but bonds declined as investors reacted to the possibility that the Federal Reserve would stop its bond buying program in the near future.
2nd Quarter Results:
The U.S. stock market had its best start to a year since 1998, but near the end of June, investors were bracing for the Federal Reserve to cut back on policies that have sent stocks soaring. The DOW ended the first six months up 14%, but all the gains came in the first five months. The DOW ended down 1.4% in June.
As the Fed hinted at pulling back on its unprecedented low-rate policies, many investors were surprised by the speed and depth of the resulting losses. Halfway through June, Fed Chairman Ben Bernanke confirmed the central bank’s intentions to start trimming aid this year. The stock swung down and then back up as the market tried to predict the fallout. Bond prices took a bigger hit than stocks as yields rose sharply. Bond prices suffered more than stock prices because in the period since the 2008 financial crisis, bond yields moved to their lowest levels in many decades. Investors viewed those low levels as unsustainable without Fed aid. They sold bonds heavily once Mr. Bernanke started talking about how soon the aid could start to be withdrawn. When yields rise bond prices move down. Year-to-date bonds are down about -3.5%.
Most Fed officials said the markets overreacted to Bernanke’s news conference, but many feel that market volatility is a normal reaction the pullback by the Fed. Investors have become dependent on the Fed’s unprecedented injections of cash into markets, including the current $85 billion-a-month bond buying program. There is no historic experience to help predict how the unwinding of such an elaborate support system will unfold, thus creating uncertainty and anxiety.
Moving Forward in 2013:
While stocks had their best first half since 1998, history suggests stock investors will make more money in the second half of the year. Since World War II, a big increase in the first half of the year has almost always been followed by more gains in the second half.
In the 68 years beginning with 1946, the S&P Index has risen 10 percent or more 23 times in the first six months of the year. During those 23 years, the market rose 19 times in the second half of the year. In fact, in eleven of those years the market went up nearly 10%! In years like this when stocks have started with a gain of over 10% the average second-half increase is 9.4%.
Past history does not, of course, predict future results. The market faces its usual hurdles. Earnings for the second quarter are going to come out in the second week of July. This always is a time of consternation. Analysts are expecting bleak results with earnings increasing 3% from a year earlier. As recently as April 1, expectations were for a 7% increase. At the beginning of the year earnings were anticipated to rise 9%. Quarterly growth over the last 15 years has averaged 8%. However, in the last eight quarters, earnings have been 4% higher than analyst predictions. This would mean a possible 7% return which would be acceptable. In addition, stocks do not look overpriced from a Price/Earnings (P/E) standpoint. The measure stands at 13.9 versus a 10 year average of 14.1.
As indicated earlier, the biggest concern for the market is when the Federal Reserve will stop propping up the market. The bond-buying program was designed to drive down borrowing costs, push up asset prices in hopes of encouraging more investment, spending and hiring in the broader economy. If the economy doesn’t do as well as expected, Fed officials have said they would hold off on further reductions in bond purchases or even increase the current bond-buying program.
Short-term interest rates have been near zero since late 2008. Indications at the June Fed meeting was that they expect to make the first interest rate increase in 2015. Investors don’t appear to be convinced but Mr. Bernanke has set out a road map to the unemployment rate for the Fed and others to follow as they move forward. The first guidepost is 7% unemployment. That rate is where the Fed expects to end its bond-buying program. Unemployment in June was 7.6%. The next benchmark is 6.5% unemployment. When the labor market reaches this level the Federal Reserve may start raising short-term interest rates.
Our belief is that the Fed will continue to keep monetary policy exceptionally easy by historical standards. Too much is at stake to have the market collapse after it has come back from such low levels in the Great Recession. We expect stock prices to continue to trend higher in the coming quarter, but bond prices to fall as investors anticipate a change in Fed policy.
Bruce A. Kraig
July 5, 2013
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