The 2nd quarter and first half of 2015 ended with a thump for investors. Although most developed equity markets traded at all-time highs during the quarter, most closed the quarter well off those highs. The S&P 500 closed the quarter with a return of 0.3% and 1.2% year to date. Growth oriented indices continue to outperform led by the tech heavy NASDAQ with a total return of 1.7%. The leading sectors in the quarter were financial services and healthcare. Small-cap growth was the leading fund category for the quarter according to Morningstar.
Foreign Markets turned in a volatile quarter. This may be an understatement when it comes to China. The Shanghai SE Composite had a steep drop to end the quarter, falling 7.3% in the month of June. The Chinese market closed the quarter up 14%, 32% year to date and 109% over the past 12 months. The Chinese government continues to wrestle with a delicate balance between capping investment euphoria and stimulating a slowing economy. All signs point to a stock market bubble as margin debt exploded and retail investors opened trading accounts at a record pace.
Europe also turned in a volatile quarter in most asset classes. After record highs for equities and bonds driven by the European Central Bank initiating Quantitative easing, investors found themselves fighting lower prices for the duration of the quarter. This was particularly evident in the bond markets as prices fell, lifting yields from negative territory. This should require careful attention as the steep drop in bond prices could be a turning point for bonds worldwide. Prices fell despite the ECB buying most bonds in the open market. It appears bond investors are demanding higher yields because of perceived risk as the European Union struggles with Greece and other highly indebted members of the union. There is no good solution for Greece as a bailout would embolden other member countries to ask for similar debt relief terms or letting Greece default could lead to a "contagion" rippling through Europe. Fears of the latter are driven by the ghosts of the recent past after the Lehman Brothers bankruptcy in 2008.
Domestically, most bond investors were "stuck in the mud" as the bond markets anticipated the long awaited first rate hike by the Federal Reserve since 2006. Bond prices move inversely to yields which put pressure on bond investor's principle. Long-term government debt had a bad quarter as prices fell over 6% and is now down over 3% year to date. Although the Fed has been preparing for the rate liftoff for years now, they cannot seem to achieve the economic backdrop to actually pull off the feat. Growth in the first quarter was negative while economic reports for the second quarter are stronger, the data remains sporadic and uneven. Estimates going forward are for the U.S. economy to finish the year averaging between 2-2.5%. The job market is on solid footing as the just reported jobless rate has fallen to 5.3%. Of course this doesn't tell the whole story as the underemployed remain high, part-time workers are trumping full-time, and the participation rate is at its lowest level in 30 years.
The Federal Reserve finds itself in a tough spot. They desperately need to raise rates to give some wiggle room to soften the blow from an eventual recession. With rates already at zero and the balance sheet at 4.5 trillion dollars (I call this leverage on the 18 trillion dollar U.S. government debt), they have no tools to battle a slow-down. At the same time, they don't want to trigger a recession by raising rates too early.
Unfortunately, the Fed is left to cover for a Federal government that has done nothing to help the economy as a whole. Instead of creating an economic backdrop that would allow the economy to flourish, they have managed to handcuff business at every turn. Taxes are too high (both corporate and individual), regulation is too great (EPA, FCC, Dodd/Frank, etc.), and healthcare continues to be a burden as premiums and deductibles skyrocket. It has never been more difficult for an entrepreneur to start a new business, historically the driver for employment gains.
Valuation, the economy performing below potential and the lack of a significant pullback in the U.S. market remain headwinds for the market. Current and longer-term measures of stock valuation remain high. The current Price to Earnings ratio on the S&P 500 is 19.2 times trailing 12 month operating earnings. The Shiller P/E, a longer term measure which uses the average operating earnings over the past 10 years (to smooth irregularities), is 27.3. This ratio has been lower 76% of the time since 1989. The last measure that I would like to highlight is called the Q ratio. The Q Ratio is the total price of the market divided by the replacement cost of all its companies.
As the chart shows, the Q ratio is also elevated at 58% above its arithmetic mean. Only during the tech bubble of 2000 was valuation as stretched. Historically, the current reading has been where the market is at or near peak valuation. All of these measures in total are a yellow flag for the market outlook and future performance. It is only a yellow flag because valuation as a timing mechanism alone has a poor track record.
What could go right and what could go wrong for investors? The bull case appears to be fairly straight forward. Investors will continue to benefit from the extraordinary support from Central banks worldwide, including but not limited to, the ECB, the Japanese Central Bank and the Bank of China. Economic growth can continue at this pace, although below potential as the global debt overhang curtails a breakout. Corporate earnings growth continues bolstered by stock buybacks and population growth. Low inflation and a lack of economic turbulence continue to drive to market gains as a whole.
I see the bear case having the upper hand at this time. A cautious stance on the market has been wrong and a difficult position to remain in. However, I believe over the fullness of time, it will pay off. Valuations remain elevated; markets have rallied without pause for 4 years and economic growth remains slow. Margin debt is in record territory (this is money borrowed to invest in the stock market), not only in the U.S. but in China also. There are reports that the "smart money" are starting to raise cash. Billionaire investors such as Carl Icahn are warning that equities are overheated. I continue to be cautious until the uninterrupted rise in U.S. equities hits a speed bump. Probabilities that something goes wrong for equity investors remain higher than normal. Although market timing should be left to the professionals, carrying higher levels of cash than normal would be a prudent move for long-term investors.