History shows us that the greatest threats to a bull market are recessions. So when the market fell quickly (-11%) one week in August, investors and the financial press were quick to round up the usual suspects to blame for the recession that was likely to occur. Heading up the list was once again China which is struggling to keep its growth rate from declining too much due to the structural changes underway in that country.

Europe was also not progressing as well as hoped for despite the quantitative easing efforts their central bankers adopted a number of months ago.  And lastly, the talking heads on CNBC, etc. once again pointed to the perceived threat of Fed interest rate hikes that would “surely” pull the economy in the wrong direction.

The Dow Jones Industrial Average, S&P 500 and NASDAQ all declined in the 6%-7% range for the third quarter and brought the year-to-date results to minus 7-8%. Fortunately, the stock markets rebounded during October, which completely recouped these losses.  In addition, Intermediate Term bonds inched 0.95% higher during the quarter as the rates on 10 year U.S. Government Bonds declined from 2.33% to 2.06% for the period.

While we were surprised to see the market recover its losses so quickly, we did not believe a recession was imminent and, therefore, thought the August market decline was one of those “normal” corrections that most market gurus have been forecasting at one time or another over the past 2-3 years. In our opinion, China is doing an okay job of transitioning to a consumption based economy. Trends in Europe are still positive and their central banks are on alert to provide additional monetary stimulus if necessary.

And, finally, we very much doubt that a modest rise in interest rates will do noticeable harm to our economy. However, we rate the overall investment environment only good at the present time and we wouldn’t be surprised to see a bump in the road before global economic growth becomes more certain.

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The U.S. Economy rebounded from its modest decline of the first quarter that suffered from inclement weather on the East Coast, a prolonged dock strike on the West Coast, an abrupt decline in oil prices and the negative impact on exports caused by a strong dollar. The rebound seemed to return economic growth to the 2% – 2.5% range, modest by historical standards, but at a level that could prove sustainable for the longer term.

Unfortunately, a number of additional negative factors external to the U.S. began to restrict economic growth again late in the second quarter. These included a replay of the Greece fiasco, an escalation of Mid East violence, Chinese economic and stock market problems, and the fears of pending Fed interest rate increases.  As a result, the S&P 500 stock index increased just 0.28% in the second quarter and only 1.23% for the first six months of the year.

Consumer Discretionary stocks increased the most (+4.78%) for the quarter and once again the Utility sector turned in the worst return at -5.78% following its first quarter decline of 5.17%.  In the bond market, interest rates turned back up during the second quarter, resulting in a modest 0.62% decline for Barclays U.S. Intermediate Government/ Credit Bond Index.

As we look into the prospects for the second half of the year, we are encouraged by the improved health of the labor market and consumer balance sheets, but at the same time, believe the economy may struggle a bit over the next few months resulting in a less than perfect investment environment.

The resurgent strength of the dollar (up 15% vs. last year) and weaker oil prices (-49%) are exerting a greater than expected negative impact on corporate sales and profits.  While these factors might keep the market from moving appreciably higher near term, we continue to maintain a positive outlook for both the economy and the stock market.

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The first quarter turned out to be one of the more volatile periods for the stock market we have seen since early 2012.  With the dollar strong and inclement weather a deterrent, investors first became concerned that economic growth was moving at a dangerously slow rate.  But then job growth picked up nicely, oil prices seemed to stabilize and investors began to regain confidence during February.  However, investors became concerned again, this time worried that the strong job gains would soon convince the Federal Reserve to raise interest rates.

The almost 0% short term interest rates that the Fed put into effect a few years ago have been the primary drivers of the economic recovery and especially important to the very good stock market we have experienced over the past 5 years.  As a result, investors have been highly sensitive to any potential upward adjustment in interest rates for quite some time now.

As a result of these on again, off again concerns, the S&P 500 stock market index rose just 0.95% during the first quarter despite no change in short term interest rates and good, albeit sub-par economic growth.  On the other hand, longer term rates did decline for the period as quantitative easing programs accelerated in Japan and began in Europe with some 10-year country government bond rates going to zero or less during the period.

This persuaded many global investors to convert their currencies into dollars and use these dollars to buy U.S. Government Bonds, thereby pushing prices higher and in turn, lowering interest rates.  As a result, the Barclays U.S. Intermediate Government Credit bond index increased 1.45% for the quarter.

Shifting gears back to the stock market, there was a relatively high degree of performance dispersion among the economic sectors during the period.  Benefitting from Government subsidies, Healthcare stocks performed the best (+6.5%) while the fear of rising interest rates hurt the Utility sector as stock prices in that category declined the most at -5.2%.

Finally, there was also a very clear performance distinction between growth and value stocks and between small, medium and large capitalization stocks.  Growth stocks outperformed in general and small capitalization stocks placed first overall.

The first quarter was a good period for active portfolio managers (i.e. stock pickers) given that the market was less correlated during the period than it has been in recent history.  According to a Barron’s article, “the 8,212 diversified equity funds tracked by Lipper…returned 2.48% for the January –March period, compared with just 0.8% for S&P 500 Index funds”. As noted earlier, the S&P 500 Index itself increased 0.95%.

The outlook for the stock market for the remainder of the year will continue to be importantly dependant on what happens to interest rates.  Overall, the global economy is still showing more signs of stagnation than not.  On the margin, the Eurozone’s economy appears to be improving, though barely.  U.S. economic growth has slowed this year and it’s not for certain that it was due primarily to bad weather.  The Japanese economy looks to be on its way to its third lost decade and China is slowing as are other major emerging markets.

This all suggests deflation is more likely the issue and raising rates would only slow business conditions further. We are also pleased to see that corporate earnings, excluding energy stocks, should increase about 8% this year, oil prices appear to be near a bottom, and the changing fundamentals of the Energy Industry promise to positively affect the economy and stock market long term.

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Wall Street forecasters believe the U.S. economy started off 2015 with the strongest momentum in at least a decade and is in better shape today than any other developed country in the world.  Importantly due to the full scale resurgence of the U.S. Energy Industry, economic growth has averaged 4.8% over the past two quarters, the highest rate in over a decade

With this non-farm payrolls are increasing at the fastest rate since 1999.  As a result, most stock and bond prices rose last year with the S&P 500 up 13.7%, the Dow Industrial Average at +10.4%, the average domestic stock mutual fund up 7.5% and the Barclay’s Government/Corporate Intermediate Bond Index rising 4.9%.  Large and middle sized stocks performed much better than small cap stocks during the year, but in the foreign stock arena, emerging market stocks declined 2.06% while foreign markets with developed markets were off 6.43%.

The equity markets in the U.S. were unusually volatile last year as investors negatively reacted to a number of events including the abrupt slow down in the economy early in the year, followed by Russia’s takeover of Crimea (March) and then the Ebola (October) crisis.

While the market recovered from all of these events by the end of October, another blow to investor confidence surfaced in December as oil prices declined sharply prompting many to assume that the global economy was in trouble. The outlook for 2015 will have a lot to do with how well the European economy holds up next year and what happens to the price of oil.

European officials recently announced quantitative monetary easing program similar to what the U.S., U.K. and Japan have been using to stimulate economic activity.  At a minimum, their efforts should keep the Eurozone from slipping into a recession, ward off deflation, and perhaps help to modestly grow the economy.  This should be enough to remove the negative aura from the market.

We’ve several times in the past made mention of the very major and positive changes expected to incur in the energy industry, and these expectations are quickly becoming a reality.  The fact that the U.S. is near or at energy independence and prices have declined, has major positive long term benefits for the U.S. and many other parts of the world.  A near term perceived problem, however, is that the sharp drop in oil and other energy prices reflects a very weak global economy.

While we do not believe that to be the case, the stock market might prove volatile until it becomes clear that oil prices have at least stabilized. Longer term, the changing complexion of the Energy Industry promises to have fundamentally positive effects on the U.S. economy and its stock market

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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.

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Volatility and a higher level of anxiety returned to the markets during the first quarter. The primary catalysts were the “evil empire’s” invasion of Crimea and a severe slowdown in the economy induced by colder than normal temperatures. The inclement weather kept consumers away from the shopping malls and Russia’s political aggressions clearly detracted from investor confidence. Fortunately, business conditions appear to be getting better with the cold weather behind us and the political issues could be dealt with by adopting some intelligent U.S. energy policies.

Value stocks clearly outperformed growth stocks during the period while midcap stocks outperformed both large and small stocks. Following several months of underperformance, utility stocks posted the best sector gains for the period and consumer discretionary stocks performed the worst, reflecting the sharp drop in economic growth.

Despite the economic slowdown, the majority of corporate earnings reported were above expectations and analysts have recently been raising their numbers for the second quarter. Overall, the market moved modestly higher during the quarter. The S&P 500 increased 1.8%. With business conditions sluggish, interest rates declined during the quarter and this provided a rebound in bond prices following last year’s 0.86% decline, the first fall-off that has occurred since the mid-1980s.

There seems to be a much higher than normal number of people calling for a severe market correction. One of the reasons often cited by naysayers is that the market is too expensive and therefore vulnerable to a bear market. The most recent earnings estimate published for the S&P 500 is $121.86 and at today’s stock prices, the market sells at a PE of 15.8x compared to 18.8x during the last market peak in 2007.

History shows that major downward moves are primarily influenced by economic recessions, not by valuation. The soft first quarter was a temporary weather-induced setback from the uptrend; recent activity has clearly improved; and with excess capacity available and no labor shortages, higher inflation is not a threat for the Federal Reserve to contend with. While this is not to say that we can’t have a meaningful correction, it’s difficult to see a full-fledged bear market on the immediate horizon.

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A year ago today, investors were losing sleep over a number of issues that appeared to be legitimate concerns. Fortunately, almost none of these concerns materialized. There was no fiscal cliff, the U.S. did not default on its debt, Europe did not disintegrate, and while China’s growth slowed, there was clearly no hard landing.

The result was an outstanding year for the U.S. stock market. The S&P 500 posted its best gain (+32.39%) since 1997 and all ten economic sectors reported gains for the period. Growth stocks outperformed value stocks and that was especially evidenced by the modest returns earned by dividend yield stocks, many of which are found in the utility and telecommunication sectors.

Both of these sectors increased less than half as much as the S&P 500! The bond market struggled through most of the year as everything but savings rates and the lowest government rates moved higher. The Intermediate Government/Credit Bond Index declined 0.86% last year and the Aaa -A Rated Corporate Bond Index fell 1.94%. A legendary baseball coach once said “never make predictions, especially about the future.”

Having said this, we believe the economic outlook is good enough to support another positive year for stocks, despite the very strong gains the market has already achieved since 2009 and the current complacent mindset of investors. The latest survey shows that a 25 year low, 15% of market forecasters are bearish on the market. This is a contrary opinion indicator which currently suggests the market is due for a correction.

On the other hand, the economy should do better than 2013 as monetary stimulus continues and last year’s fiscal tightening from increased payroll taxes and the sequester lessens. Bottom line, any correction that might occur is not likely to reverse the market’s longer term uptrend.

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After suffering through a plethora of negative events for more than three years, almost nothing appears to meaningfully raise the anxiety level of investors these days. We commented early in the year that a better housing market, permanent changes to our tax code, and fixes made to the European banking system should substantially lessen the market’s volatility and risk exposure.

The virtually crisis-free environment over much of the past twelve months has resulted in good stocks going up and problem stocks going down. This more normal investment environment is expected to continue the majority of time over the next several years. The good news is that our company-specific, fundamental type selection process tends to perform well during periods like these.

Growth stocks significantly outperformed at all market capitalization levels and for the second quarter in a row, while the higher dividend paying utility, telecommunication and consumer staples stocks collectively lost money. Small Capitalization stocks outperformed both mid-cap and large-cap stocks. The S&P 500 Indexes rose 6.02% and 5.24%, respectively.

Interest rates rose slightly during the period, resulting in a modest 0.62% gain for Barclay’s Intermediate Government/Credit Index and a 0.72% gain for the S&P 2018 Municipal Bond Index. Looking into the fourth quarter; U.S. economic growth is slower but not negative; Europe seems to be gaining some traction for the first time since 2007; the political wrangling has been put on hold for 90 days; the sequester is reducing Government debt; and the appointment of Janet Yellon to head up the Fed may provide even more stimulus to the economy and markets than “helicopter Ben” bestowed upon us.

Short term, the market is overbought and investor sentiment is a bit complacent. While these last two factors have typically resulted in a temporary market consolidation, we haven’t had a meaningful correction since the market began its turnaround in 2009, and this pattern might just remain the same this time around.

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