You have found the section where we share with you our current thoughts on the financial markets. On a rotating basis we will post copies of letters to our clients, results from our market models, our thoughts on current events and their impact on the markets or current recommended reading.
July was certainly a wakeup call for somnolent stock market bulls. For the last few months the market drifted quietly higher and volatility was virtually non-existent. But the highs of July 3rd ended all that. Apparently the fireworks of the 4th aroused the Wall Street bears and markets tumbled as sellers came out of the woodwork.
July was the worst month in several years as the Dow and the S&P 500 each lost about 1.5%. Small stocks, represented by the Russell 2000 index lost almost 5.5% for the month. Many commentators are now calling for a correction or a bear market. Before we comment on our outlook we would like to make several other observations concerning market price action.
First we would like to point out that the Dow and S&P 500 are narrow slices of the overall equity market. The Russell 3000 covers almost the entire universe of tradable stocks. Its average stock is already down almost 20% and nearly half of the index is down over 20%. And looking at all stocks traded, only 4% are within 2% of their highs. This is down sharply from the 38% at that level when July began. Even high yield bonds are selling off with the iShares High Yield ETF losing over 3% last week alone. Why do we take note of these market minutiae? Only to point out that outside of the large stock universe much of the selloff has already taken place. Riskier assets have been sold and without an unexpected shock the market may not fall much further. We don’t have to look far for such a shock. Trouble in the Middle East could spin out of control. The Ukraine could escalate with Russia cutting off food or fuel to Europe. The economy in China could weaken and banks in Europe could collapse. None of these are new problems, and it is possible they could worsen without causing further havoc in the investment markets. This is most likely a function of valuation. So how are things valued?
Currently markets are actually fairly valued. After the latest quarter’s earnings the S&P price earnings ratio is again below average. Many small stocks have sold down to less inflated valuations and high yield bonds are approaching more reasonable spreads to Treasuries. Although the markets are becoming oversold we expect some hesitation before traders are ready to jump back in. Part of this is due to the summer seasonality, with many investors still on vacation. Part is due to uncertainty over interest rates. Going forward our biggest concern is this fall’s elections. With corporate profit margins at an all-time high anything that upsets them, such as tax or health care reform, is a major concern and a source of market volatility. We think the next several months of political posturing will cause that heightened market volatility. Although that volatility will be hard on the nerves it will present us with an opportunity to put the proceeds from your earlier portfolio sales back to work.
As always we appreciate your patronage and encourage you to call us with your questions or comments.
CJ Brott Karen Burns
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