Q2 2016 Update

July 13, 2016 | by Scott Miller, Jr.

There was no shortage of news during the first half of 2016. There was also no shortage of volatility, as we predicted in our first quarter newsletter.

We spent a great deal of time in that newsletter discussing crude oil prices, both the positives for the consumers and the negatives for some U.S. companies. A CNN headline on January 12th stated, “Oil crashes to $30 a barrel.” Less than one week later, WTI settled at $26.55, which at that time was a low close for the year. Equity markets followed crudes lead, but as crude recovered, so did the Dow and S&P 500. The current price is just under $50 a barrel, calming market fears for now. Investors who sold the small cap Russell 2000 index at the low during the correction earlier this year missed a recovery with a return of approximately 19%, as of June 30, 2016. This is another example of why we continue to stress a long-term approach to investing.

Recently, more big news kept everyone on edge as the result of the Brexit vote surprised a large majority of market analysts and investors. This caused a two day panic as the Dow Jones fell 610 points on the Friday after the vote. Monday was not much better with the Dow falling another 260 points; a two day total loss that wiped out 3 trillion dollars globally. The two day total was the largest dollar loss ever, according to S&P Dow Jones Indices. This was not, however, the biggest percentage loss, which occurred October 19, 1987. Losses were not contained to the U.S., but were felt throughout the entire world with both bulls and bears making their positions known. Some were calling for a recession in Great Britain, some in Europe and E.U. nations, some for China, and some predicting a worldwide recession. Friday evening after the Brexit vote I had a friend brag that he got totally out of the market that day. My response to him, “When are you going to get back in?” His response, “Touché.”  Remember the problem with timing the market is that you need to be correct twice, once on when to get out and again on when to get back in. Most experts cannot consistently predict these moves correctly once let alone twice which is required to be successful.

What will the next major event be and what should we watch as the market volatility continues to create investor uncertainty? The Federal Reserve is of course somewhat unpredictable, but certainly has the power to move markets. A more dovish U.S. Federal Reserve may lead to a short-term boost in the equity markets, even with the somewhat elevated company valuations. The presidential election, which may be the most contentious in my lifetime, will certainly be something to watch. Domestic markets typically experience market volatility during the election season even in the best of times. But, “It’s the economy stupid,” a variation of the phrase James Carville coined during the 1992 campaign, that matters most. Markets react emotionally short-term but over the long-term, valuations are tied to economic fundamentals. Corporate earnings season began on July 11th and future earnings projections will be in the forefront of investors’ minds during July and August. Will the world-wide economy experience significant negative earnings?—any changes here will cause major volatility. Will the central bankers save the day if earnings falter by continuing to cut interest rates and execute bond buying programs? For now, the U.S. has held off in its long promised increase in interest rates, another short-term positive. Standard and Poor’s lowered the bond rating for Great Britain from AAA to AA the day following the Brexit vote. About 5 years ago (August 2011), our own U.S. bond rating was cut to AA, creating negative sentiment amongst market prognosticators and causing many pessimistic investors to exit the market. In the long run, investors that reacted emotionally and sold investments were wrong.

“We are expecting growth in the second half of the year,” says Jeffery Immelt in the WSJ, but the GE chairman made that prediction before the vote. Since the vote, not everyone agrees on the direction of the economy but consensus seems to move toward moderate growth as employment finally has reached acceptable levels. Will inflation follow as often happens after strong employment numbers and wage increases? It is certain that with interest rates at such low levels income investors have become desperate to find yield. We are very cautious on this area of the market where investors are reaching for yield which causes elevated prices for purchases of income producing securities. Elevated prices create risk causing many investors to believe they are being safe when actually they are taking on much more risk than they realize. Many Master Limited Partnership (MLP) investors realized these dangers over the last year. What’s an investor to do? One must position their portfolio, in our opinion, with some downside protection, watch both short and long-term movements of the dollar, be vigilant in following the price and demand of crude oil world-wide, and watch not only present earnings but future projections. While equity prices seem high, the possibility of a bond bubble as world economic stimulus drives interest rates to even lower levels than last year is more of a concern of mine than the stock market itself. Most important, however, is that you keep your long-term objectives and expectations in the forefront and not allow sensational journalism to control your emotions.

Please let us know of any changes in your personal situation, as you know we always appreciate your questions. Hoping to hear from you soon.