Our Thoughts

Quarter in Review: Cautious Optimism

The U.S. stock market reported very modest gains in the first quarter of the year, and, it wasn’t until the final trading day that we would know whether the quarterly returns would be slightly positive or slightly negative.  In the end, the widely-quoted S&P 500 index of large company stocks gained 1.81% in the first three months of the year.  The comparable Russell 2000 small-cap index rose 1.12%.  Looking abroad, the EAFE index of large international companies in developed economies – Europe, Australia, and the Far East – was flat for the quarter, with a 0% return.

Bonds are still yielding far less than their historical averages, but the trend has been interesting.  Treasury bills with 3-month and 6-month maturities are yielding less than they did at this time last year, with rates of 0.03% and 0.05% respectively.  Longer-term Treasuries have seen rates drop modestly to 0.12% (1-year), 2.73% (10-year) and 3.52% (30-year).  Corporate bonds have also dropped a bit; you can now buy 10-year AAA rated corporates and get a 3.13% yield, or go out 20 years and get 3.97%.  This, of course, confounds the experts who have been predicting for more than five years that rates would be rising dramatically, decimating bond portfolios.

Commodities, as measured by the Dow Jones UBS Commodities Index, gained 6.99% over the quarter.  Real estate investment trusts, as measured by the FTSE NAREIT Index, were up 8.52% in the first quarter, despite losing ground in the month of March.

 

When you look at the returns of 2014’s first quarter in the context of the long bull market recovery from the Great Recession, you can’t help seeing a bit of a slowdown.  The markets did rise for the quarter, but it was a pretty choppy ride, and it is hard to find any reputable commentator who is predicting another 30+% return this year.  Instead, you are hearing a lot of speculation about whether the bull market is about to end, and the markets will “correct” – Wall Street speak for at least a 10% downturn.

 

 

The argument for a correction is that, compared to some traditional measures, stocks are at least fairly priced and they may be trading above prices we consider to be historical norms.  Some people worry that certain drivers of U.S. economic growth may be slowing down, even though the most recent reports show continuing gains in employment and growth in factory orders.  

On the other hand, you are seldom near a market top when so many people are speculating that you are.  Market tops seem to have the magical ability to silence doubters precisely when they should be most doubtful, and investors are seldom cautious near the peaks. 

Moreover, the fact that the combined returns of small (1.12%) and midcap (3.5%) equities outgained large caps suggests that the companies that depend on the U.S. economy are strengthening a bit, while those that are dependent on profits overseas may be weakening.  This leads to another type of speculation.  Some analysts wonder if foreign stocks will provide higher returns than the U.S. markets over the next cycle.

The problem with all of this analysis is that it is really speculation about the unknowable future.  When markets get slightly overvalued, history tells us that they can get much more expensive as markets climb rapidly toward frothy tops, and those who trimmed back on their stock exposure are kicking themselves for missing those extra returns.  History also tells us that corrections and bear markets never announce themselves in advance.  If stocks go on sale in the next quarter or two, it will give us a chance to buy more on the cheap.  If they go up, we will report the good news with a renewed sense of caution while less seasoned investors grow more enthusiastic.