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Summertime Blues

Here we are at the midpoint of 2013. It’s been a very good year for US stocks, with returns, measured by the S&P 500, up13.8%. In contrast, most categories of fixed income (TIPS, US Treasuries, US Corporates) are down in price, with the longer maturities suffering the most. Other asset classes have performed even worse, especially the BRIC countries (Brazil, Russia, India and China) gold and silver. Global asset allocation strategies have not fared well this year.

For the month of June, stock prices fell 1.5%, the first monthly decline this year. According to Bespoke Investment Group, the recent stock pullback was 5.8% and lasted 34 days. Since the bull market began in March of ’09, this was the 17th such pullback of 5% or more, with the average decline being 8.3% lasting 25 days. The last true rocky patch stocks experienced was May – September 2011 when stocks fell five straight months for a cumulative decline of over 18%.

I have been waiting for a pullback, only to allow us to buy some stocks we like, at somewhat better prices. The S&P is slightly below its 50-day, so we are not backing up the truck, but selectively adding to some favored names. Stock prices are up 10 of the last 12 months — so with the exception of the most recent month, the uptrend remains in place. Price behavior over the coming months will tell if June was a blip or the start of a trend change.

The recent fly in the ointment is investor concern with the long-anticipated change in policy from the Federal Reserve. Beginning with the financial crisis in 2008, Fed policy has been accommodative to repair and rebuild confidence in the financial markets. This project is largely accomplished and the reversal of Fed policy (tapering) and the ultimate change in direction of Fed Funds (short interest rates), is expected.

The recent jump in interest rates pushed the yield on the US 10-Year Treasury over 2.6%. For perspective, it peaked at 15.6% in late 1981, and hit an all-time low of 1.4% June 2012. If rates have in fact begun to turn, it will be a long process and premised more on economic fundamentals (GDP growth and inflation expectations) than traders playing their own game of musical chairs. I expect rates to revert, rather than to continue their recent move, and any upward trend to be gradual.

At the moment, the economy is growing modestly and forecast to pick up speed in 2014. Housing data is compelling, with the Case-Shiller Home Price Indices continuing its advance. The expected inflation levels remain low and non-threatening.

In my opinion, we have been placing too much emphasis on monetary policy and not nearly enough on fiscal policy. Some constructive policy coming out of Washington, DC would go a long way toward promoting job growth and enhancing the competitiveness of US businesses.

Known risks to the stock market include faltering GDP, analyst downward earnings revisions, inflation (suppressing the market P/E ratio), rising commodity (input) costs and rising energy prices. None of these risks are apparent today. Indirect risks could include hot spots such as the Middle East and North Korea, slowing economic growth in China and the re-emergence of financial-fiscal crises in the Euro-zone.

While everyone is on the road to the beach, they can take comfort in the favorable historical behavior of stocks in July. Bespoke data shows positive returns for the month of July 65% of the time over the last 20 years. Bespoke data further shows that in years where the S&P 500 has returned greater than 10% in the first half of the year, the second half of the year has been positive 72% of the time, with average returns of 5%.

Earnings season kicks off with Alcoa scheduled to report on the 8th. Earnings will be critical to stock behavior. In one sense, earnings announcements may re-focus investors away from the yield curve. I am hopeful that some solid results will shore up what has been a trend of declining growth forecasts from analysts. The lowered expectation is for only 0.8% earnings growth over Q12013. Meeting these lowered growth figures and limiting the negative revisions to the second half outlook are pivotal.

Near term, I expect stock prices to remain volatile. There will no doubt be some earnings disappointments that catch investors off-guard. Longer term, I think the outlook for stocks is attractive, based on current estimates and valuation levels. I also anticipate the interest rate concerns that roiled markets recently will taper off, and rates will normalize. Have a great start to your summer, and if we have not spoken recently or if you have any questions, please do not hesitate to call.

Bruce Hotaling

CFA Managing Partner

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