The second quarter concluded with a flurry of global economic news that rattled stock markets and cut into the quarter’s gains. Stocks are struggling to post gains in 2015. Very little price progress has been made as each quarterly closing price for the S&P 500 is near the preceding quarterly closing price. Greece was a major cause of market jitters at various points during the quarter, and particularly during the last few days of June as the country announced it would default on its month-end debt repayment to the IMF.
China was another source of news at quarter-end as the People’s Bank of China undertook a surprise rate cut, along with other easing measures. China’s economic growth has slowed as policy makers seek to contain overall credit growth and redirect the economy toward a more sustainable path. Closer to the United States, Puerto Rico announced at the end of June that it would be unable to handle full repayment of its municipal debt. All of these situations outside the U.S. were responsible for the increased volatility in the U.S. markets at quarter-end.
As we enter the third quarter, Greece will most likely move away from dominating investor attention, and the focus will likely shift to Fed policy and interest rates. With an improving, but still moderately growing U.S. economy (that is not triggering inflation), the pace of the Fed increase in interest rates would appear to be measured. Also, absent inflation, a sharp move higher in bond yields should not develop, in which case a premium valuation for equities is warranted. However, in an effort to avoid being a “blind bull”, our caution has admittedly increased with a multitude of issues at hand (The Fed and interest rates, European Union, current valuations, slowing earnings), leaving the market vulnerable to pullbacks and could be a catalyst for a correction, something on the order of a 10% decline. Based on history alone we are overdue for one. The S&P 500 has now gone almost four years or 45 months without at least a 10% decline, making this the third longest such stretch since World War II. Prior to this recent run, market corrections occurred roughly once a year on average. We note all of this, not as a short-term market prediction but as a plausible shorter-term scenario to be aware of and be prepared for.
Although investors should be aware of the vulnerabilities of a market in the current state, they should likewise not become too defensive or complacent.
It’s important to note that having a long “time horizon”, when owning stocks, is critical because inevitably there are going to be shorter-term negative surprises, and when these surprises occur investors should be prepared for increased market volatility given that markets often over-react to transitory shorter-term news or outcomes. In those moments, it is useful to remember that volatility is the shorter-term discomfort an investor must experience in order to earn attractive longer-term returns from owning stocks. For it is exactly those volatile market environments that can create compelling long term investment opportunities, in the form of tactical asset allocation opportunities for us and great stock and bond picking opportunities for the managers we use.