The stock market was basically flat in the second quarter of 2015. The S&P 500 was up 0.3% and was up 1.2% for the year.
2nd Quarter Results:
Most funds were negative in the second quarter. Even though markets hit all-time highs in May, stocks sold off near the end of the June in response to Greece, China, and interest rate concerns. Bonds were negative due to the fear of an interest rate hike by the Federal Reserve Bank.
The prime reason for the late quarter decline was the Greece crisis. The Greeks were basically playing a game of chicken with the European Union. They recently voted no to proposals that would have given them credit but at severe restrictions on spending and pension outlays. They hoped the negative vote would get Greece better terms in new negotiations. Greece makes up 2% of the Union’s GDP. Its economy is as large as Louisiana. We believe the biggest threat is if the EU makes restrictions easier. This will be a signal to the weaker members of the EU, such as Spain, Italy, and Portugal, that they can renege on their loans as well.
Longer term this should not have much impact on the U.S. In fact, recently it appeared that the Greece situation may be resolved. Greek leaders seem to have approved a new settlement which does make financial restrictions more difficult. We will see if this is acceptable to the Greek population as a whole.
Outlook for the 3rd Quarter:
The three areas of concern going forward are outlined below:
The Chinese stock market soared 120% in about eight months from November 2014 through mid-June 2015. Over the last three weeks it has lost 33% of its value or 3.5 trillion dollars. The big worry is that a contagion from stock market losses could further dampen the country’s slowing economy. Chinese officials have stepped in almost every day to support the falling market. These moves have included lowering interest rates, changing margin requirements for investors, and even providing liquidity for certain companies to buy stocks. None of these measures have stemmed the selling.
Foreigners own only 1.5% of the Chinese stock market so that is not the problem. The main concern is that it could hinder long-term growth prospects for China. Large stock market losses could force millions of Chinese investors to rein in personal consumption. China represents 15% of world GDP. Reduction in Chinese growth and consumption could impact companies that sell their products to China and cause declines in production in other countries around the globe. We will have to see how this affects worldwide growth.
Interest rate increases have been a financial concern for several years now. Near zero interest rates have been in existence since 2009. Easy money has spurred the stock market to make its extraordinary recovery from the sharp fall in 2008. At some point, rates will be raised by the Federal Reserve as a way to slow anticipated inflation. As of yet there is low inflation, however, and the Fed has been putting off taking this move. Inflation is less than 2% over the past year, but it is now expected that rates will start to be raised near the end of the year.
When rates move up, bond prices fall, and anticipation of these raises has caused bond yields to move up from their historically low levels. In return, bonds were mostly negative for the second quarter. Drops in bonds are affected by a bond’s duration. Longer-term bonds have longer durations and will go down more for each 1% drop in a bond’s price than a shorter term bond with a shorter duration. For example, a bond with a duration of 10 years will go down 10% for each 1% rise in interest rates. If rates go up 1% over a year, that bond will decline 10% in value. The Vanguard Long-Term Bond Index fund has a duration of 14.8 years. It goes up a lot when interest rates fall but can fall a lot if rates move up. By comparison, the Vanguard Short-term bond index has a duration of 1.6 years. This means that it will fall about 1.6% if rates move up 1% compared to a fall of 14.8% for the Long-term bond index. This is why short-term funds are generally safer in rising interest rate environments.
2nd Quarter Earning Reports:
After worrying about the Greeks, the Chinese, and interest rates, investors are hopeful that U.S. corporate earnings will bring more reassuring news this month. Companies have started to report and early announcements bode well for markets unnerved by worrisome headlines and a shaky U.S. stock market.
Earnings results have grown every quarter since late 2009, supporting a bull market during this time. For this 2nd quarter, companies are forecast to report that earnings fell an average of 4.5% compared to a year ago. Much of that decline, however, is due to lower profits at energy companies which have been hit by the collapse of oil prices.
Companies often have the habit of low-balling their forecasts, giving them an easier hurdle to clear when the report final results. For example, early forecasts for the first quarter showed that companies would report a 3.2% decline in earnings. Once all the numbers were in, earnings climbed 4.2%.
The estimate is that once energy companies are excluded (which are expected to decline 61%), companies’ profits are expected to climb about 3.8%. Many are optimistic about companies that are dependent on consumer spending. Hiring has improved this year and there are signs that wages are increasing slightly. In addition, lower oil prices mean lower gas prices which put more money in peoples’ pockets. This bodes well for the economy overall.
Our clients' portfolios continue to do well. One of the main reasons for continued good performance is the Vanguard Healthcare fund. This fund is up 14% so far in 2015. It was up 28% in 2014 and 43% in 2013. We see no reason that this trend should not continue. This fund makes up 39% of the total portfolio which is appropriate.
We are not overly concerned with the drop in bond prices. If our clients hold bonds, they have short durations (the amount that bonds will fall with each 1% rise in interest rates) and rises in interest rates should be pretty much offset by higher returns from the bond yields.
We are comfortable with the composition of our clients' portfolios. We have good diversification across industry lines. The equity funds are mostly in the large-cap area. This is the safest sector if markets should retreat. The funds owned have done extremely well over the last six years and we expect that they will continue to prosper through the rest of the year.
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