In a Nutshell
The second quarter was a yawner overall for the U.S. stock market. With all the concerns about rising interest rates, Greece, and more recently China, this year has been one of the least volatile on record. Through the end of June, the S&P 500 has not closed more than 3.5% above or below where it started in January. This is a first for the history of this index, which spans more than 50 years (Source: Bespoke Investment Group).
Bonds had a more difficult time of it this past quarter with all the major indexes posting a loss. Expectations of a rate hike by the Federal Reserve later this year pushed bond yields up and when yields go up, prices usually go down.
Because bonds lost ground, the classic balanced portfolio of 60% large company stocks and 40% high quality bonds was down this quarter. If rates continue to rise, the bond portion of the portfolio, which has acted as a mainsail in a steady breeze and provided positive performance, may turn into an anchor.
More excitement was found in commodities and real estate. Although with real estate, down almost 11% this quarter, it wasn’t the kind of ride most investors want. Oil and agricultural products were the big positive drivers of commodities.
U.S. Stocks Continue a Long Term Positive Trend
The U.S. stock market continues to be the leading asset class when looking at longer term trends (Source: Dorsey Wright & Associates). As such, they continue to be overweighted in our portfolios. That being said, large company stocks as represented by the S&P 500 were essentially flat for the quarter and are barely positive year-to-date. Smaller companies didn’t fare quite as well as their larger brethren this quarter but have outperformed by a measurable amount this year.
If we look under the hood of the U.S. market, we find that in a continuation of the first quarter, growth outperformed value. Looking at sectors, HealthCare continues to be a leading theme this year, although it was joined this quarter by Banks. Historically, banks tend to be more profitable in rising rate environments as the spread, the difference between the interest they can charge on loans and the interest they have to pay on deposits, goes up.
On the flip side, industries that have a lot of debt, such as Utilities and REITs (Real Estate Investment Trusts), will see their profit margins shrink as rates rise. The prices of REITs reflected that expectation by being one of the worst performing sectors of the market this quarter. Usually, rising interest rates signal an improving economy. If that’s the case here, REITs should be able to raise rents in the future to compensate.
What are you in the mood for, Greek or Chinese?
Flip on your favorite business news station these days and you’re likely to see the coverage dominated by Greece or China. That is, when the IT guys are doing their job of keeping the NYSE computer systems running.
When ranking the longer term performance of the major asset classes, International Stocks hold the 2nd position, just ahead of Bonds (Source: Dorsey Wright & Associates). Asia continued to be the leading region with China leading the way. China has also been one of the most volatile markets this year, especially over the first couple of weeks of July. So far, the effect of this volatility has had limited impact on the larger stock markets in the region, such as Japan and Australia. This is something we will keep an eye on, however.
Greece has been, well Greece. Since it became an independent country in 1832, Greece has been in default off and on for 90 years, or about half the time (Source: Forbes). Although it was one of the poorer performing stock markets this quarter, it’s a very small economy, the Vermont of the EU, if you will. It’s been getting all the attention recently because of the potential implications if it leaves the EU. In particular, would it influence other larger EU countries such as Italy and Spain, which also have weak economies and mountains of debt.
The Bond Seesaw
Investment grade bonds struggled this quarter as interest rates rose. The easiest way I’ve found to understand how bond prices and interest rates are related is to picture a seesaw with bond prices one one side and interest rates on the other. When interest rates go down, bond prices usually go up and when rates go up, prices usually go down.
This effect is more pronounced with bonds that have longer maturities. For example, the index used in the table at the beginning of this post tracks U.S. Treasury bonds that will mature in the next 7 to 10 years. If we look at another index (TLT) which tracks Treasuries maturing in the next 20-30 years, it fell 9.49% this quarter.
For the past 33 years, interest rates have been gradually declining. During that time, all investors needed to do with the bond portion of their portfolio was invest in U.S. Treasuries and high quality corporate bonds. If we’ve reached the end of that long term trend, then more thought will need to be put into how that “safe” money is best deployed to keep it from being a drag on the overall portfolio.
Commodities in general have been in a downtrend since the fall of 2012. Although one of the few bright spots this quarter, on a relative strength basis, they are still behind all other major asset classes (Source: Dorsey Wright & Associates). We continue to avoid them in our portfolios.
Oil and its cousin, gasoline, were the primary performance drivers this quarter. Agricultural commodities such as wheat and cocoa were also strong performers with cocoa up 21%. Stock up on those Hershey bars!