Second Quarter 2014 Market Review

The stock market continued to move higher in the second quarter of 2014 despite the abrupt halt of Japan’s economic turnaround, the geopolitical issues in the Ukraine and the Middle East, and concerns that US economic growth was in jeopardy. But in the end, what matters most to the US Stock market is that our economy moves in a positive direction and that inflation does not get out of hand to the upside. Fortunately, government estimates of inflation indicate that it is well under control and the recent upturn in the economy is a clear signal that business conditions are moving in a positive direction.

As a result, the S&P 500 Composite Index of stocks increased 5.23% during the second quarter and 7.14% for the first half of 2014. Mid and Large Cap stocks easily outperformed small cap issues in both the growth and value categories for the second quarter. All ten economic sectors posted positive results for the quarter and the three biggest contributors to the first half were Technology (1), Health Care (2), and Energy (3).

Looking into the months ahead, it’s important to recognize that recessions are primarily caused by the Federal Reserve when it tightens credit conditions (raises interest rates) to slow economic growth that in turn helps to slow inflation rates. We do not believe a policy to tighten credit is imminent, especially given today’s circumstances. The obvious reason is that inflation trends have been modest in most cases and there also appears to be a good deal of excess productive capacity available in today’s global market place.

A second, and possibly more important reason, is that many major governments of the world need inflation (read higher taxes) to help service their debt obligations which have increased substantially over the past several years. On the other hand, should the Fed and/or other central bankers of the world tighten credit availability too soon, deflation and an extremely difficult financial environment would likely result. Fortunately, Central Bankers around the world are keenly aware of this scenario and, therefore, not likely to let the world fall into a deflationary mode.

As a consequence, it may be quite some time before interest rates are increased worldwide given the slower growth in China, the almost recessionary conditions in Japan and parts of Europe, and the relatively modest growth we are experiencing in the US. For the most part, the Federal Reserve has been on its own when it comes to reigniting growth in our economy and even though our economy is in better shape than others, it is evident that the Fed’s efforts have not led to an environment of self-sustaining growth.

And even if the Fed moves to increase rates sometime in the future, their influence on world markets is lessening given increased globalization. For instance, today’s U.S. 10-year Government Bond trades at an extremely low rate of 2.41%; heavily influenced by Spain’s 2.15% rate even though it is obviously a much riskier investment.

If world interest rates remain low and the investing public begins to believe they will stay low for more than just the short term, stock prices could move higher from current levels since history shows they are undervalued based on today’s interest rates. For example, a recent study by a well-respected financial firm indicated that based on current interest rates and consensus earnings estimates, the S&P 500 is currently about 7. 5% undervalued.

Please understand that there are a lot of “ifs” included in this scenario and that the implied revaluation is likely to unfold over the next year or so. In the meantime, our economy has improved, corporate earnings are improving, and the overall environment for stocks on balance appears positive.