First Quarter Market Commentary-media-1

‘Have you guessed the riddle yet?’ the Hatter said, turning to Alice again.
‘No, I give it up,’ Alice replied: ‘what’s the answer?’
‘I haven’t the slightest idea,’ said the Hatter.
‘Nor I,’ said the March Hare.
Alice sighed wearily. ‘I think you might do something better with the time,’ she said, ‘than waste it in asking riddles that have no answers.’

– Lewis Carroll, Alice in Wonderland

Well, the year’s half over, and it’s time for our much anticipated, highly celebrated, never boring fireside chat on the condition of things in general. Veteran readers know that, like Alice, we won’t waste time trying to make predictions, or solve problems that have no answers. Still, it’s good to stop mid-stream here and take stock of where we are, why we’re here, and where we may go in the future.

Overall Economic Conditions

Let’s start off with a review of overall economic conditions. Domestically, the plowhorse economy continues to trudge forward. Nothing exciting, mind you, but still forward progress. Most forecasters project the US economy to grow this year between 2-3% overall, and we seem to be on pace for this. While it isn’t terrible, it’s not terribly exciting, either. There are a number of reasons cited for this continued slow growth. First, consumers – the largest customer of the economy, continue to spend, but low wage growth has stunted overall spending rates. It’s true that employment growth is healthy, but wage growth is a very important element of economic expansion. As wages go, so goes growth. We’re seeing some signs that wage growth is improving, but slowly. Second, federal, state, and local government spending remains tepid compared to past recoveries. (Next to consumers, the government is the economy’s largest customer.) There are many other smaller contributors to the equation, but these two are the largest. Until we see a meaningful boost in productivity and wage growth, we’re likely to be stuck in a slow growth mode. If you’re inclined, watch these two indicators for signs of change.

Overseas, we’ve seen encouraging signs that the recession hangover is finally beginning to wane. Developed countries in Europe have seen more robust growth this year following four years of tough slogging and stagnation. (We’ll get to Greece in a minute.) Japan – dare we say it – appears to actually be growing once again. And the developing economies in Asia and elsewhere, while a mixed bag, are generally poised to follow larger economies upward. None of this will be a straight march northward, but overall the global economic mood is positive.

Investment Markets: Down The Rabbit Hole

Turning our attention to the investment markets requires us to venture down the rabbit hole a bit.

The past 18 months have resulted in very modest returns for diversified investors. As of today, equity markets are essentially flat for the year. There are a few reasons for this that merit mention:

First, there have been precious few places to invest beyond equity markets for the prospect of a decent return on capital. As most everyone knows, interest-bearing investments such as CDs, money markets, and short-term bonds remain stuck in neutral, thanks largely to the continued tinkering of the Federal Reserve. And now, the European Central Banks are following the Fed’s lead, flooding their economies with liquidity and driving rates down further. In fact, short-term interest rates in several countries actually turned negative for brief period, meaning investors were willing to accept less than their principal back for the protection of most of it. (Alice in Wonderland, indeed.) The upshot of all this is that interest rates are destined to stay low for the foreseeable future, providing investors with little opportunity to earn anything on short-term, principal-protected instruments. While the Fed may bump rates a bit later this year, it will be largely symbolic.

As a result, the equity markets have provided one of the few places to earn a potential return. So, every time we see a slight contraction in stock prices, new money rushes in to fill the void. Witness: historically, equity markets have on average experienced an inter-year decline of between -10% to -14%. We haven’t seen one in 4 years now. There’s simply too much money on the sidelines waiting for the slightest chance to get in the game. So equity markets effectively tread water.

Still, it could be worse. While stocks may be fairly to slightly overvalued, we’re not in bubble territory by any historical measures. (Technology stocks are another story. We would advise caution here, as valuations have gotten a bit lofty.) Generally, companies have continued to grow their earnings as the economy has slowly expanded. And stock market values are nothing more than a reflection of forward looking expectations. Still, a normal market contraction would be healthy for the growth prospects for long term investors. The current (ongoing) Greek crisis may be just the excuse the markets need to take a breather.

In other investment categories, commodities have meandered about this year following last year’s rout in oil prices. Commodity returns have been negative for three years now, reflecting the softened demand from China and other developing markets. When these markets begin to expand again, the demand for raw materials will follow their lead. Note that commodities like energy and metals go through normal expansions and contractions based on demand, and the contractions don’t last forever.

Lastly, real estate has been the brightest star over the past year. New home sales, housing starts, and existing home sales all are continuing to expand. It’s worth noting that in virtually every past economic recovery, real estate led the way. While real estate returns are down slightly this year after last years advances, the overall measures are showing continued healthy expansion.

Perspective on Greece

In terms of storm clouds on the horizon, there are always a few of them. Greece, however, isn’t one of them – at least in the big picture. This is a very fluid situation, so by the time you read this, the short term picture may have changed a bit. But as long term investors, we’re more interested in long term effects. So here’s some perspective on Greece.

Don’t let anyone tell you Greece is sticking up for its dignity by fighting austerity. After several years of minor reforms, Greece elected a far left government back in January. Instead of trying to boost growth, cut spending, and pay its debts, the government is saying it won’t cut retirement benefits and wants to raise taxes on what little private sector it has left.  In short, Greece finally ran out of other people’s money. So what does the new government do? It blames the only groups willing to lend it money and refuses to cut spending. (This is in spite of watching their sister country Ireland, who took their medicine and is now the fastest growing economy in Europe, thank you.) They don’t want to make the hard choices, so they are putting it to a vote. Again.

It’s worth noting that Greece’s total GDP is about the size of metropolitan Detroit. When Detroit defaulted, the US – and even Michigan – survived just fine. Detroit had already wasted the money it had borrowed, and so has Greece. The only thing left is recognizing the loss. So their threat to leave the EU and default on their debt wouldn’t create long term chaos, but would most likely result in temporary market weakness. The market’s reaction to Greece this week isn’t about Greece; it’s fear of the contagion spreading to other European countries, which the authorities in the European Union have worked hard to contain. Like past Greek comedies and tragedies, this one will play itself out and pass one way or the other, but it won’t result in long-term catastrophe as long as the ripple effect is contained. In the short term, be prepared for some fluctuations.

Other possible distractions include the usual geopolitical issues in the Middle East, the beginning political sideshow for the 2016 election (high comedy at its best), and Putin’s theatrics in Russia (Jeff will actually be in the former USSR later this month to find out what all the fuss is about – stay tuned for a first-hand report.) And, there’s always the overblown worry about the Fed raising interest rates. Sooner or later, rates will rise. But based on all the above, it’s hard to imagine a scenario where the rise isn’t gradual and deliberate, giving markets the opportunity to absorb the effects with manageable disruption.

Properly Diversified? Stand Firm.

So. Based on all this, what’s an investor to do? Diversified returns for the past 18 months, while positive, have been nothing to write home about. The natural reaction to muted returns for unguided, impatient investors is to “do something”. As Alice noted in our opening quote, you’d be better off not wasting your time (or money) guessing at riddles which have no answers. The decision to “try something different” in the hope that you’ll be right can have meaningful unintended consequences. If you’re properly diversified for your long term goals, don’t just do something, stand there. Trust in history, have faith in the future, and exercise patience. It’s a formula that’s proven itself far more successful than chasing rabbits down holes.

See you next quarter!