"As the markets bath in the euphoria of recent jobs and economic numbers that have exceeded expectations, we remain steadfast voices of reason..."

Portfolio Update - June 2014

"Unemployment remains elevated and underutilization in the labor market remains significant…"
“…. I believe that long-term unemployment might fall appreciably if economic conditions were stronger. --Janet Yellen, June 2014


  • The economy continues to grow at a modest rate across a broad spectrum of industries
  • Jobs being created broadly but not sufficiently to satisfy the Federal Reserve’s belief that stronger economic measures are needed aside from monetary policy changes
  • Fed continues to taper bond purchases, and is on target to consider reduced rates in 2015 even as Chairman Yellen seeks to take a strong Main Street approach
  • Global activities could increase volatility in markets with unrest in Mideast, Ukraine
  • Most asset groups have shown gains for the year thus far, most expected to continue
  • Party on.As the markets bath in the euphoria of recent jobs and economic numbers that have exceeded expectations, we remain steadfast voices of reason and thoughtful caution while the party rages around the punch bowl and beer pong tables. Certainly we’re keenly aware of the latest job reports that show over 275,000 jobs added in June, and nearly 300,000 in May. Hip to the job expansion throughout almost the entirety of the economy. Keen to underemployment rates having plunged from nearly 16% to 12% and an unemployment rate now just a tad over 6%, down from nearly 10% in early 2009. Well apprised that car and home sales are growing, consumer confidence is rising, industrial output increasing. Well versed in the facts that nearly every major leading and economic indicator, from durable goods orders, consumer sentiment, industrial output, employment, housing and construction, jobless claims, is pointing in the positive direction.

    And all that growth taking place with inflation remaining at a mere 2%, along with miniscule wage pressures to hamper corporate profits and pressure inflation. What could be bad?

    Some would seek to spoil that party by directing our attention to the geopolitical traumas – Iraq, Syria, Israel, Ukraine, Egypt -- that pepper our headlines daily. Or the negative GDP growth in the first quarter of the year that seems only partly explained away by the arctic-like winter many labored through. Or that this post recession expansion is among the limpest in history, with expected GDP for 2014 to be just over 2%, and barely over 3% for 2015. Or that after a long bull market run-up since the March 2009 lows, some rain must fall on the parade party.

    But we’re not prepared to shut off the music and send everyone home just yet. In fact, we’ve been encouraging more attendance in the investment scene over time than most, seen more positives in this post recession than many of the fickle talking heads over these last few years despite every effort by Washington to bring the economy to its knees.

    What we won’t get is drunk or a sugar rush over the latest information. But despite saying “I told you so”, we will say regarding this economy, that after lopping off the noise of the spikey peaks and troughs, while the economy continues to grow at a far slower-than-desirable rate thanks to Congressional subterfuge, grow it will. That despite Congress’ best efforts to stymie growth by refusal to make the critical investments in infrastructure, research, and important social net programs, that the primal economic forces that underpin our economy continue to press on and should continue to do so for the foreseeable future, and the equity markets, despite moving towards valuations that are on the high side of normal, have the potential to continue to rally through the next year.

    Janet Yellen’s Fed (Yellen is the Federal Reserve Chair, having replaced Ben Bernanke this year) seems in agreement, or at least Yellen herself is. By continuing to keep Fed funds levels next to 0 percent even while continuing to taper bond purchases by $10 billion a month (versus shutting it down altogether), Yellen is making a clear statement that she remains focused on jobs and the fact that we have just barely reached employment levels that existed prior to the recession; that wages have improved at pitiful rates, that many people on Main Street still feel “poor”, and that this just isn’t good enough.

    Meanwhile, on the other side of the Atlantic, among the developed countries, GDP growth continues at a glacial rate, enough so that the central banks there are more concerned about stimulating growth and monetary easing just as we are contemplating an end to these actions. If we can’t get past the first knock-out round of the World Cup, at least we can lead in audacity and people-friendly monetary policy.

    Bond markets. So for over a year now, we have expressed concern that the basic animal spirits that drive investors to panicky behavior would invariably kick the way-lower-than-normal interest rates in the bond and credit markets upward toward their historic averages, particularly when it’s realized that the Fed is cutting back its easy money policies and the inevitable fears of inflation begin to circulate among the economic air currents. This is not got in the short term: as you probably know by now, when interest rates rise in the bond markets, bond values go down. We recall vividly, when in May of 2013, then Fed Chair Bernanke erred unforgivably, surprising the bond markets by suggesting that the end of Fed interest rate easing through bond purchases was nigh, which resulted in a bloodbath for bond investors as interest rates shot up. Sure, a few overly opportunistic hedge funds were knocked down a few notches as Bernanke hoped, but many retirees already struggling with low interest income got to watch their account values take a huge hit. Since then, we and our investors have been very sensitive to any other changes the Fed might be considering, and for good reason. And we don’t expect Janet Yellen to be quite so disinterested in the small investor.

    But as we’ve mentioned in newletters past, reversion to the mean is a fundamental and almost unavoidable force of nature, and surely our historically low interest rates must rise over time, and rates for 10 year Treasuries by now should be approaching 3.5% or more. But low and behold, the strangest of things occurred over this last year: interest rates, even after moving up to nearly 3%, then dropped back to the 2.5% levels. Bonds not only recovered, but performed nicely, once again proving the sagacity of those proponents of asset allocation even in periods of darkness (which generally includes us, but in this case we were just plain lucky). Some may have thought us nuts for keeping an allocation in bonds over this last year – certainly a few of our clients must have considered egging the mailbox – but with bonds having risen nearly 5% this past year, we feel redeemed. Imagine – an economic expansion and job growth from May of 2013 through June of 2014, and still, interest rates have barely budged. Who’d have thunk it?

    An unusual instance when the rising tide has raised all boats. Indeed, 2014 has been positive for not just bonds, but practically every asset class. Led by large cap equities this time, the markets have been teetering around record highs for the last several months. Certainly, small caps have trailed significantly, and commodities and other classes have trailed in returns compared to the larger cap stocks, but growth has still occurred.

    So the question is whether the good news will continue, whether the 3% plus growth levels we’ve probably seen since February are merely a rebound from that one terrible month, or whether this economic rally is truly sustainable? The other question is, will stocks continue to move in lockstep with economic growth, now that they’re trading at over 19 times earnings – the higher side of normal? Some are calling for a market correction as the Dow flirts with 17,000. And what, with all the turmoil in the Mideast, will happen to oil prices, which have risen nearly 10% in light of the uncertainty, and could rise significantly higher should things deteriorate further?

    Which leads us, again, to inflation, the management of which is one of the Fed’s key mandates. Inflation naturally kicks in when an economy grows as the availability of money to businesses and individuals results in increased purchasing demand which, in turn, tends to drive prices up. In a demand environment, prices of homes, oil and fuel, healthcare, goods and services tend to rise and in order to control this rise, the Federal Reserve seeks to “tighten” its money supply. This means that it will seek to drive up interest rates, making borrowing more expensive, typically slowing or controlling economic growth and demand, and bringing prices down. We’re usually well into this phase seven years after a recession. But not this time.

    Even a rise to 2.1% in the May consumer price index, a major jump from earlier in the year, still evoked mostly yawns. And core PCE – the measure of inflation typically used by the Fed, which hit 1.6% growth, more than many expected however, and largely impacted by rising healthcare costs met with only modest concern. Why?

    Perhaps because wage inflation, has, in fact, thus far been stagnant. And inflation indicators used by the Fed are showing little, if no real inflationary activity. Add to that, Janet Yellen’s deep concern about the lack of sufficient economic benefit enjoyed by the 99 percentile, strong anti-inflation measures by the Fed seem far in the future, and inflation, in a real sense, which is a concern of some Fed members, is not at the top of Yellen’s list of anxieties. So any heavy-handed efforts by the Fed to strongly throttle inflation seem unlikely in the near term. Yellen has gone out of her way recently to make it clear that economic growth is projected to be lower than previously expected, and we’d be surprised if she pressed for higher rates any time before 2015. She’s also made it especially clear that stimulating job growth and economic expansion is of paramount importance.

    Much of Europe, on the other hand, remains on another point of the recession rebound curve. With central banks looking, finally, to pump life into these languishing economies after clear evidence of their earlier predictably failed efforts at “starve the patient” economic medicine, an increase in growth there seems more promising, and stands to provide opportunities in the equity sectors.

    But we see some improvement happening in Asia as well. Prime Minister Abe, in Japan, is now moving forward with his next tier of promising economic reforms. China’s slowdown has long been factored in to their equity pricing and they, Taiwan, and Korea show promising growth. Even India, the huge laggard, appears poised for improvement with the election of a government finally bent on implementing major reforms.

    Portfolios. So where does that lead us with respect to portfolios. Here, a modest inflexion point is taking place in that almost all economic sectors are moving positively. Even commodities and particularly gold are rebounding. The most visible headwinds really are seen as geopolitical at the moment. Should Mideast and Ukraine-Russia tensions escalate, the markets will certainly react, particularly if impacts are anticipated in the oil and gas markets. But even with that, events are likely to be short-lived, if not completely contained. So while prices might spike for the time being, things will likely settle down unless something of a very high magnitude of negative impact takes place. Those events may even represent opportunities.

    So equities, broadly are likely to benefit from this environment as long as corporate earnings grow. If they don’t grow, or if this next corporate earnings season disappoints, a significant pullback wouldn’t be a surprise. Indeed, a moderate correction catalyzed by events or headlines, could give the equity markets a reason to correct for a time.

    Bonds, however, are in a much more confusing and unpredictable (at least for the near term) situation. The events of last May informed us, that even with vigilance, things can turn suddenly, driven not so much by the economic fundamentals, but the whims of the Fed or central banks abroad. The good news here is that they can recover lost ground. But with so many seeking and chasing yield, high yield investments are looking increasingly to be riskier than we’d like to see for their level of reward. While we wouldn’t suggest cutting back the bond asset classes too far below a reasonable percentage, being scout-like vigilant should be the rule of the day: i.e. be prepared if the Fed signals are relayed to the marketplace as Bernanke did back in May of 2013. Or if inflation generally picks up. Or oil prices skyrocket. You get the idea.

    So there you have it. Party, but party with caution. Appoint your designated driver. And pray that the mid-term elections don’t leave us with a Congress even more inclined to inhibit economic growth than the one we’ve endured recently. Let’s also hope that amidst the heat of summer, cooler heads find a way to prevail in those areas of the world suffering in turmoil and intolerance.

    Happy 4th of July to all.
    Ron Stein, CFP

    Good Harvest Financial Group


    Disclaimer: each investor has different needs. The information herein should not be used to direct investment decisions without assistance. No guarantees can be made or implied in the above information.