The first quarter of 2014 was broadly positive for stocks and bonds, but it was a choppy ride. At one point in January, the S&P 500 (large company stocks) lost 6%, and market pundits began predicting a 10-20% correction. Instead share prices rebounded in February and March lifting the index to a 2% return for the first quarter and new highs as of this writing. US small company stocks (Russell 2000) continued their rise but were outperformed by their larger brethren. International stocks (MSCI EAFE) were essentially even as struggling European economies grappled with Russia’s invasion of Crimea, and Japan gave back 10% in the first quarter after being the hottest market in 2013. Emerging markets were modestly down. The Barclays Aggregate (broad based bond market) was up 2% as 10-year US Treasury yields fell 31 basis points. Meanwhile, Commodities and REITs had nice quarters rising 7% and 9%, respectively. Overall, gains of this amplitude were not unexpected, but were certainly appreciated given the potential for a correction after last year’s big rally and recent soft economic reports.
2014 Economic Indicators
The big debate now in the markets is whether disappointing economic indicators in the first quarter were due to bad winter weather or a real economic slowdown. Companies will begin releasing first quarter earnings soon and expectations are they will be mostly flat. Looking out at full year 2014, Wall Street expects earnings to rise 8-10%, meaning most of this growth would come in the second half of this year. We expect companies to blame any declines in productivity or sales on the record cold weather so analysts will focus more on companies’ outlooks. It’s quite possible that first quarter demand was only pushed back, pointing to better numbers in the spring and summer. Economic indicators we follow, including the ISM Manufacturing Index, Industrial Production and Non-Farm Payroll, suggest the economy is still improving and this purported slowdown is just a weather related blip.
In January of this year, Janet Yellen began her tenure as Federal Reserve Chairman. Unfortunately, she did not get off to a favorable start in her first conference with the press. During the Q&A session, she inferred that the Fed could begin tightening (or raising) interest rates six months after they end their Quantitative Easing (“QE”) program. This statement surprised the bond market, and immediately the 2 year U.S. Treasury yield jumped 11 basis points or over 30%. Chairman Yellen clarified the Fed’s intent and the markets settled down, but speculation about the end of easing is out there. There continues to be a lot of healthy debate from investors as to how much of the markets gains have been driven by Fed policy. Many well-respected investors exclaimed that the Fed’s QE would stoke high inflation. These investors were right about inflation; they just got the type of inflation wrong. The Fed’s QE stoked “asset inflation” as the Fed explicitly targeted a wealth effect aiding housing prices and the stock market. Seeing that we are most likely 8-12 months from the Fed completely winding down their asset purchases, it made me think of what is really the driving force of this market? I recently watched the movie, “The Hunger Games: Catching Fire,” in which different tributes (or participants) battle each other in a life or death scenario. The heroine, Katniss Everdeen, had previously survived her initial battle royale in the first installment, but has been brought back again as a participant by the evil President Snow. In this second installment, the most dangerous adversary is not another combatant, it is a computer-controlled environment. As one would expect, it doesn’t always work out like the controllers want, similar to the potential consequences of unprecedented Federal Reserve policies. Supply and demand and other fundamental economic forces have taken a back seat to the controlling central bank in the past few years. As the Fed winds down their purchases, there will most likely be gyrations and possibly shock waves in the financial environment, and we won’t know if it ends happily until the credits roll. However, the long-term benefit is that the market will again be driven more on the fundamentals and less on the Fed’s policies.
Waverly Advisors is focused on providing investment returns that meet our clients’ needs over a long time horizon. Stocks are not cheap, but valuations are not excessive. We do not believe we are at the edge of a precipice like 1929, 2000 or 2008. Prices may be a little ahead of where they would be without the Fed’s intervention, but history tells us they can get more expensive. History also tells us that corrections (to be expected) and bear markets (feared) never announce themselves in advance. Pessimistic economic forecasters missed the shale gas revolution, new mobile technology, a reviving manufacturing sector, and much of this rally. The pat explanation for their current fears is Fed action, but perhaps they underestimate the resilience of the US economy — it’s getting warmer, and who knows, it could even catch fire.