Mid-Year Stock Market Update: 'Near Record Highs' But It Doesn't Feel That Way

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Summary

The first half of 2016's stock market activity could be summarized by one word: volatility.

I have modest expectations for the rest of the year: Valuations for large-cap stocks remain high, and earnings growth looks tepid.

Smaller-cap stocks, value stocks and those with unique situations continue to look much more appealing.

The first half of 2016 could be summarized by one word: "volatility." The S&P 500 Index returned a respectable 3.8% (including dividends), but this skips through the brisk -11% decline to start the year, followed by the sharp +15% recovery to near-record highs by April 20. The up-and-down action resumed with the -5.3% two-day Brexit sell-off and +4.9% bounce the next two days. Currently, the S&P 500 is less than 1% away from its all-time highs - but with all the volatility combined with almost no change in the index level over the past 12 months, it's hard to say it really feels that way.

Behind the performance of the broad index was a wide disparity among groups of stocks. The Utility sector, often thought of as uninspiring, returned 23.4%, while the Financial sector lost 3.1%. Technology stocks also struggled, as evidenced by the tech-heavy NASDAQ Composite dropping 3.3% over the first half of the year. Among styles, value stocks are having a good year while growth stocks have struggled. The Russell 1000 Value Index, which focuses on larger-cap stocks, has returned 6.3% year-to-date, compared to a 1.4% return for the Russell 1000 Growth Index.

Small-cap U.S. stocks, as measured by the Russell 2000 Index, have returned 2.2%, a little less than the S&P 500. International stocks (based on the MSCI EAFE Index) have declined by 6.3%, with the weakness coming from European stocks. Emerging market stocks have been surprisingly strong, up 5.0%.

Bonds have produced strong returns, as falling yields pushed up bond prices. The Barclays U.S. Aggregate Index, which measures a mix of government and corporate bonds, returned 5.3% through mid-year. Generally, the longer-term the bond, the better the return: the Barclays Long U.S. Treasury Index, which includes 10+ year maturity Treasury bonds, returned 14.5%. The 9.3% return for high yield bonds (as measured by the BofA Merrill Lynch High Yield Index) reflects a recovery from the sell-off last year. Lower quality CCC-rated bonds generated a remarkable 19.0% return.

Many commodities also staged a comeback during the first half, led by oil's roughly 30% increase since January 1. Gold was another stellar performer, gaining 24.6%.

So, where do we go from here? With the S&P 500 Index having already exceeded the 3% return anticipated in the January issue of my distressed investing newsletter, I have modest expectations for the rest of the year. Valuations for large-cap stocks remain high, and earnings growth looks tepid. Stocks with "low volatility" and stable earnings appear particularly expensive. Smaller-cap stocks, value stocks and those with unique situations continue to look much more appealing.

With weak global growth and persistently low inflation, combined with the upcoming (and likely colorful) U.S. presidential election and the possibility of additional volatility-producing surprises like the Brexit vote, we expect that the Federal Reserve will remain very cautious about raising interest rates. (Although I continue to advise against wasting time trying to guess what the Fed will do.) While possible, it seems unlikely that government and higher-quality corporate bond prices can continue to produce strong returns (driven by ever-lower yields) as nearly $12 trillion in government debt around the world now trades at negative yields. Higher quality high yield bonds have a better outlook, but we'd be wary of dipping too far down the quality spectrum. I expect defaults outside of the energy sector to increase in the coming quarters.

In general, I expect the U.S. economy to remain an island of relative economic health, with slow growth and little inflation.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.