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GWYNEDD WEALTH PARTNERS


Market Update – January 2016

With the beginning of a new year and given the recent volatility in the financial markets, I wanted to give my thoughts and perspective on what to expect going forward.  As I stated in my last update in August, this is NOT 2008.  However, it is important to emphasize that corrections do happen and sometimes can be very unnerving.  It is during times like these that planning, asset allocation and being proactive are of the utmost importance. As we have been communicating to all of our clients, and as I stated in August, after seven years of a bull market that has seen only one correction of more than 9% (19% in the summer of 2011) we are due for a correction of 10%, 15% or even 20%.  Technically we are still in the correction that began in May 2015 as the market has not achieved a new high since then.  A correction of up to 20 percent, although uncomfortable to go through, is normal and healthy for the market.

As I write this report after the market close on Friday January 15, 2016, the Dow Jones Industrial Average stands at 15,988 which is 13% below its all-time high achieved in May 2015 and 8% lower than it started 2016.  We are solidly in correction territory but considerably less than a bear market correction of more than 20%. The strong initial rebound off of the August, 2015 lows gave hope that the worst of the correction was behind us.  Nevertheless, a retest of the August levels is extremely normal and that is where we are right now.

The Economy

Much has been made recently about the possibility that the United States is entering into a recession.  Historically, recessions happen every five to seven years.  Our last one was the Great Recession of 2008 so it would not be unusual for one to occur now or at some point in the near future.  One reliable indicator of a recession is the difference in the yields of the two year and ten year U.S. Government bonds.  When the difference, or spread, between the two bond yields approaches 0%, we are either in a recession or one is eminent.  Today that spread is at 1.1%.  This indicates a softening in the economy but not a recession.

That being said, the economy continues to chug along.  We continue to slowly expand and contrary to popular belief, we are not contracting.  Fourth quarter Gross Domestic Product (GDP) is expected to come in at approximately 1% which is less than optimal but still positive.  Jobs continue to grow at more than 200,000 per month.  Inflation is just under the Federal Reserve’s target of 2% and well below the historical average of 3.63%. Manufacturing is slowing but it is important to point out that manufacturing constitutes only 12% of the U.S. economy.  The services sectors make up fully 86% and these nonmanufacturing sectors appear to be holding up just fine.  There are issues with the economy but overall it is relatively sound.

It is highly unusual for a bear market in stocks (20%+ correction) to occur when we are not in a recession.  Of the 15 bear markets since 1928, only five have taken place when the U.S. was not in a recession. These five were typically brought on by an event outside of the U.S. such as the emerging market crisis of 1998.  These types of bear markets are relatively short, approximately five months, and not very deep, on average a 26% correction and more importantly have a minor impact on the U.S. economy.  The fear being represented in the markets today is that there could be a crisis in the energy sector and that China’s slowdown could impact the global economy.  Whether these fears are valid sometimes does not matter as the markets can trade down on fear alone.  During these times, it is important to keep our composure and our perspective and to be proactive in our approach.

Oil, Energy and Commodities

Oil, along with China, continue to dominate the headlines.  Since June 2014 the price for a barrel of oil (West Texas Intermediate) has fallen from $107 to a recent low of $29.  This has wreaked havoc on the stock prices of oil companies such as Exxon and Chevron.  Many energy companies have seen their stock prices go down anywhere from 35% – 80%. The depressed level of commodities in general has kept U.S. inflationlow which benefits both manufacturers and consumers alike.  All of us can remember $4/gallon for premium gasoline just a short while ago.  Premium is now around $2.50 locally and much lower elsewhere in the country.  This price reduction has huge benefits for consumers but does not do great things for energy sector companies.

There are multiple reasons why oil continues to fall in price, but it really comes down to Economics 101:  supply and demand.  The Saudis and Russia continue to produce oil at the same levels as before the price drop that started in 2014 and do so without regard for price.  Typically, OPEC adjusts its production to maintain a certain (higher) price level.  The common belief has been that the U.S. shale oil producers neededa $50 – $60 dollar per barrel price level to break even.  OPEC has felt threatened by the surge in production from these shale producers over the last few years.  As the price of oil started to go down in 2014, OPEC did not attempt to prop up the price.  Instead, it kept production up in an effort to run the higher cost shale producers out of business.

Surprisingly, the U.S. shale oil producers have been able to break even at lower price levels than previously thought and thus continue to produce at relatively high levels.  Combine these high production levels with Iran now coming on line producing at least 500,000 barrels/day, and China slowing down and consuming less oil, and you have a recipe for the price of oil to continue to go down.   Where this ends nobody knows but $10 – $20 oil is not out of the question.  The concern is that many of the U.S. shale oil producers will not be able to continue operating with oil below the $30 – $40 level.  The fear that several will file bankruptcy and there could be a ripple effect that spreads has roiled the high yield debt market and added to the uneasiness in the stock market.  The end of the stock market correction will most likely coincide with the bottom in oil.

The Federal Reserve and Interest Rates

Well they finally did it!  Janet Yellen and the gang finally raised the target for the Federal Funds rate to .25%.  As I stated in August, the most likely scenario was for a small .25% increase and that when it finally happened it would be a non-event.  They did it and it was a non-event.  In fact, the stock market actually rallied significantly immediately after the increase.  The increase in rates is not the cause of the recent stock market weakness. Such a miniscule increase does not have that much of an impact.  The perception of tightening may have an impact, but the actual increase does not.

The conversation has now shifted to how many times the Fed will raise rates in 2016 and beyond.  The initial consensus was four more raises in 2016.  That opinion has now changed.  Economic output and inflation are still too low to warrant aggressive increases in interest rates.  Oil has not found its footing and the slowdown in China is a concern.  Historically, the Fed has raised rates and bond yields have gone up because there was a threat of inflation.  It will be difficult for the Fed to raise rates very quickly and by very much.  As I stated in August, shorter term instruments of less than five years will see minor price declines but intermediate to long term bonds will most likely stabilize.  This has proven to be accurate and in fact longer term bonds have risen in value since the Fed increase.  We had already adjusted the bond portion of our portfolios in preparation for the rise in rates and recently took additional steps to capitalize on the more favorable outlook for longer term bonds.

Developed International

Developed international countries such as Germany, France and England have been experiencing the easy monetary policies that the U.S. initiated seven years ago for about a year now.  These economies, with the exception of Germany, have struggled.  When the U.S. stock market goes down, Developed International stock markets tend to trade in tandem with the U.S. stock market and go down with it.  This is what is happening right now.  There is less correlation between the two on the way up and often one market’s gains will far outpace the other.  This is what occurred in the first half of 2015 when the European stock markets, especially Germany, moved up significantly more than the U.S.

China is a fairly large trading partner of the Eurozone and China’s continued currency devaluation and economic slowdown will create temporary headwinds for the European countries.  That said, although Developed International is an important component of a diversified portfolio, we have recently taken steps to reduce our exposure to these markets until this correction runs its course.  The expectation is for Developed International to have its day in the sun before too long.

China and Emerging Markets

China is changing.  China is no longer the manufacturer for the rest of the world.  That title is slowly being transferred to India and Indonesia.  China is transitioning to a consumption and service economy.  As such its economic output is slowing from what was 7%+ growth per year since 1990 to 4% – 6% growth.  This has had a tremendous impact on the demand for oil and commodities.  China’s consumption of oil and commodities has grown exponentially over the last 25 years and now that it is receding it is having a major negative affect on oil prices.

China currently represents 15% of the global economy and its slow-down will have an impact on emerging markets and Europe.  It will have less of an impact on the U.S.  Currently, approximately 8% of all U.S. merchandise exports are to China.  We import far more goods from China than from any other country.  We import approximately four times as many goods from China as we export to it.  China’s continued devaluation of its currency, the Yuan, makes its goods cheaper in dollar terms.  The biggest winners will be the American Consumer.  It is expected that other Asian countries will be forced to devalue their currencies to be competitive with China.  All-in-all, goods imported to the U.S. from these countries and sold in stores like Walmart and Costco will be cheaper. The currency devaluation and resulting cheaper imports will be deflationary in our country and will put more pressure on the Fed to be slow and meager when raising rates.
We have exited our Emerging Markets position.

Summary

The U.S. stock market is oversold and due for a short-term bounce.   However, I do not believe the ultimate bottom of this correction has been reached yet.  I expect volatility will continue for the foreseeable future.  The back drop for the U.S. economy is relatively sound and the stock market is fairly valued.  Both of these do not portend for an extended correction or bear market.  Once this correction runs its course, I am expecting a very strong upward move in stocks.  We are monitoring all portfolios daily and are at the ready to add to or trim our exposure should certain price levels be reached or if the economic picture should suddenly change.  As previously noted, we have already taken certain measures to adjust the portfolios where appropriate.

I always maintain that planning, research, diversification and proactivity are the keys to being a successful long term investor!

 


 

Market Update – August 2015

Given the recent volatility and downdraft in the stock market, I wanted to give my thoughts and perspective on what to expect going forward. As highlighted above, this is NOT 2008. I know many of you are having flashbacks to that very tumultuous time but rest assured this is a very different environment than we were in seven years ago. As we have been communicating to all of our clients, after six years of a bull market that has seen only one correction of more than 9% (19% in the summer of 2011) we are due for a correction of 10%, 15% or even 20%. This is normal and healthy for the market.
As I write this report after the market close on Monday August 24, 2015, the Dow Jones Industrial Average stands at 15,874 which is 13% below its all-time high achieved a few months ago and 11% lower than it started the year. We are solidly in correction territory but considerably less than a bear market correction of more than 20%.

The Economy

The economy is very different today than in 2008. We are expanding (albeit slowly) and not contracting. Manufacturing is expanding. Housing is expanding in a healthy fashion. Jobs are growing at more than 200,000 per month. Inflation is just under the Federal Reserve’s target of 2% and well below the historical average of 3.63%. It is extremely unusual (it actually has never happened before) for the U.S. stock market to enter a bear market when the U.S. economy is expanding and trending upwards.

Oil, Energy and Commodities

Much has been made about the collapse in oil and commodity prices. Since June of 2014 the price for a barrel of oil (West Texas Intermediate) has fallen from $107 to a recent low of $38. This has wreaked havoc on the stock prices of oil companies such as Exxon and Chevron. Many energy companies have seen their stock prices go down anywhere from 35% – 70%. Energy as a whole makes up approximately 15% of the major stock indexes. Notwithstanding these facts, the stock market showed tremendous resilience earlier this year and made a new high on May 19. The depressed level of commodities in general has kept U.S. inflation low which benefits both manufactures and consumers alike. Oil could continue to go lower but we are much closer to a bottom in oil prices than a top. The eventual turnaround in oil prices will have a major positive impact on the stock market in general.

The Federal Reserve and Interest Rates

Even more has been made about the Federal Reserve and the raising of interest rates. Whenever it is a slow news day on the Financial News networks, they can always talk about the Fed and speculate as to when and how much it will raise interest rates. The Fed is like a bad Quarterback that drops back to pass on every play only to hold the ball and get sacked each time. By the second half of the game, everyone knows the Quarterback (the Fed) is going to pass (raise rates) and we suspect at some point the QB (the Fed) will actually complete a pass (raise rates). By the second half of the game this is a big yawn. Eventually the Fed will raise rates and when it happens it will be a non-event. The market may hiccup for a few days but more likely it will take it in stride and go about its business. Also remember that in all likelihood the rate rise will be a miniscule .25%. Historically, the Fed has raised rates and bond yields have gone up because there was a threat of inflation. As noted before, inflation is and has been under control for a long time. It will be difficult for the Fed to raise rates very quickly and by very much. What this means for bonds is that shorter term instruments of less than five years will see minor price declines but intermediate to long term bonds will most likely stabilize. We have already adjusted the bond portion of our portfolios in preparation for the rise in rates.

Developed International and Greece

Developed international countries such as Germany, France and England are just now experiencing the easy monetary policies that the U.S. initiated six years ago. These economies, with the exception of Germany, have struggled. This is changing. The expectation is for Developed international to have its day in the sun before too long. China is a fairly large trading partner of the Eurozone and the China currency devaluation will create a temporary headwind for the European countries. That said, Developed Europe still presents an excellent long term value opportunity and is an important component of a diversified portfolio.
Greece produces and exports hardly anything and is not a player on the world’s economic stage. The fear of Greece leaving the Eurozone and a domino effect happening with other countries such as Spain and Portugal also leaving has abated. The conversation has now shifted to China.

China and Emerging Markets

China devalued its currency about 3% last week. This will have more of an impact on other Asian countries than on the U.S. The biggest winners will be the American Consumer. It is expected that other Asian countries will be forced to devalue their currencies to be competitive with China. All-in-all, goods imported to the U.S. from these countries and sold in stores like Walmart and Costco will be cheaper. The U.S. imports approximately four times as many goods from China as we export to China. The losers in all of this will be U.S. exporters. When taken in total, the exposure of U.S. exporters to all of Asia is about 9%. U.S. companies like Apple and General Motors manufacture in China what they sell in China so the devaluation will not have a serious impact on most large U.S. companies. The currency devaluation and resulting cheaper imports will be deflationary in our country and will put more pressure on the Fed to be slow and meager when raising rates.
China’s perceived economic slowdown will affect the other emerging countries such as Brazil and Russia. These emerging countries provide the raw materials that China needs for manufacturing. If the China slowdown is real (and it is very hard to tell) this will negatively impact the rest of the Emerging Markets. Much of this has already been factored into the Emerging Market companies and the current sell off in these stocks is more fear based than reality based. We are closely monitoring the China/Emerging story.

Summary

Rates will slowly rise, inflation will stay low and the U.S. economy will continue to show a solid, if mediocre, upward trend in growth. I expect all of these factors to create a very positive long term environment for U.S. stocks. I do expect stock market volatility to continue for the next few months. When the dust settles, I am expecting a very strong upward move in stocks. We are monitoring all portfolios daily and are at the ready to trim our exposure should certain price levels be violated or if the economic picture should suddenly change.
I always maintain that planning, research, diversification and proactivity are the keys to being a successful long term investor!

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