A funny thing happened on the way to a great 2nd quarter for stocks – Greece defaulted on her June 30th debt payment to the IMF (International Monetary Fund). The markets responded as expected and gave back most of the gains achieved during the quarter. After a July 5th voter referendum it appears the Greek people were serious in electing a Socialist leader who pledged to reverse the austerity demands attached to their prior bailouts. As of this writing it remains to be seen if the country will be successful in another debt renegotiation or instead, exit the eurozone and suffer the consequences. Only time will tell and your investment strategy should not be based on what Greece may or may not do, now or in the future.
On a more encouraging note, the second quarter of 2015 marked the end of a long and painful recovery in the NASDAQ Composite Index from a -77.42% decline which began on March 10, 2000 concurrent with the bursting of the dot-com bubble. The next year would bring terrorists attacks followed in 2002 by the total collapse of investor confidence in the wake of corporate scandals such as Enron and World Com. It was the financial market’s version of the perfect storm. The NASDAQ Composite sell-off initiated the first of two mega bear markets within a ten-year span during which the broader market (S&P 500) fell by approximately 50% (both times).
The tech-heavy NASDAQ Composite was flying high in early 2000 fueled by investor beliefs that we had entered a new paradigm in which Internet-related companies would soon replace traditional brick and mortar enterprises. These companies were trading at incredible premiums and some young start-ups with little or no earnings had higher market valuations than economic stalwarts such as Proctor & Gamble. It didn’t take long before the bloom was off the tech rose and the new paradigm became just another lesson learned the hard way. The good news is that the NASDAQ Composite did recover, although many of the companies that were in the index in early 2000 are no longer around. The bad news is that it took 15 years for that recovery to happen. Patient and broadly diversified investors who did not sell out at the bottom (many did) saw their losses returned to them in full. Many confident investors who stayed the course and methodically continued with their monthly savings program not only overcame their losses, but profited handsomely.
Economic and Market Conditions
Contrary to the perpetual predictions of an increase in the Fed Funds rate, it has yet to materialize. Although, after their June meeting, Federal Reserve Chairwoman Janet Yellen re-affirmed that the Fed will likely raise rates later this year. The U.S. economy is in good shape, but there is just enough slack that the Fed continues in its cautious approach. During the first quarter the economy actually contracted at a -0.20% annual rate as measured by gross domestic product (GDP) which is the broadest sum of goods and services produced. This compares to a fourth quarter annualized growth rate of 2.2%. The first quarter’s down tick was due to bad weather (which shut down much of the northeast), a dock strike on the west coast, reduced activity in the oil patch and a strong dollar which hurt exports. The numbers aren’t out yet but predictions are for a rebound in 2Q-GDP of about 2.5%. Still, this recovery cycle is sub-par as witnessed by a pattern of two steps forward and one step back. Fed Governor Jerome Powell recently said there is a 50-50 chance the economy will realize the necessary conditions to raise rates in September, but that was before the Greek debt default.
The stock market is six years into a recovery from very depressed levels, and that recovery is due to solid and improving economic fundamentals. The unemployment rate is now 5.3%, job openings are at a record high, and weekly unemployment claims are at pre-recession lows. Housing starts and auto sales are recovering nicely but still have room for improvement. Those two sectors together account for 10.5% of GDP, up from the recession low of about 9%. However, the long-term average is 13%, so we still have a lot of upside potential. Inflation has been running consistently below the Fed’s forecast, and according to some economists, it is apt to remain low.
As mentioned previously, stocks ended the quarter in a down draft due to Greece’s inability to get her fiscal house in order. Most major sectors barely broke even and U.S. mid-sized companies (S&P MidCap 400) lost -1.06% during the period. For the first half of 2015, developed international markets (MSCI EAFE) produced the largest gain, up 5.52%. Market interest rates rose slightly in 2Q-15, producing a modest -0.02% loss in our bond benchmark index (Barclays Capital 1-5 Year Government/Credit). Through the first six months of the year, that same bond benchmark returned 0.94%. Remember that bond prices move inversely to interest rates, so when rates rise, prices fall to bring the bond’s remaining yield-to-maturity in line with current market rates.
We believe earnings ultimately determine stock prices. The consensus operating earnings forecast for those companies that comprise the S&P 500 is $119 and $134 respectively for 2015 and 2016, compared to $113 in 2014 and $107 in 2013. At current prices, that equates to a P/E (Price/Earnings) ratio of about 17.5, which is in line with long-term averages. The market will always experience periodic setbacks be it due to an increase in interest rates, inflation concerns or Greek debt problems. Greece will either get her house in order or she won’t, but the rest of the world will move on. As long as earnings grow, stock prices should eventually follow.
Lessons Learned the Hard Way
There are many lessons that could or should be learned from the aforementioned -77.42% drop in the NASDAQ Composite and the 15 years it took to recover. Stock prices can and do fall in value periodically, sometimes significantly, and successful investing requires a long-term perspective combined with the proper attitude. The velocity at which markets or company share prices move often results in a paralysis from which investors are unable to react. Not only can this happen on the downside, but also on the upside. Once caught on the wrong side of a price movement you are in a bad place from which it can be difficult to recover, and this is why market-timing should be avoided. Those who over-weighted technology stocks in 2000 learned the hard way that being concentrated in the wrong sector at the wrong time can be disastrous. Even worse were those who placed large bets on just one or two companies and then witnessed an implosion in their share prices. That is not investing; it is speculating, and it pays to know the difference.
No-one has a crystal ball to consistently predict which company or sector will out-perform the overall market, and there is literally no substitute for a broadly diversified, periodically rebalanced, low cost, tax-efficient investment strategy. At the end of the day, it matters little what happens in Greece or if the Fed raises interest rates. The truly important attributes for success include a willingness to live within your means, to save aggressively and invest prudently, and to have a goals-based plan that you can monitor periodically, adjusting as needed. Additionally, a little patience can go a long way.