Market Strategy Radar Screen Weekly July 05, 2016

Happy Birthday, USA!

Investors stateside seemed surprised to learn that US equities made gains in H1:2016

Even though it’s too early to tell how the process of Brexit (Britain’s exit from the European Union) will unfold, the complexity of what lies ahead to be dealt with politically, structurally and economically is likely to be historically significant if not daunting. In the process ahead participants will learn what it is like to unwind a social and economic treaty of magnitude and tenure such as that of the UK’s membership in the EU.

We are reminded that in considering what might lie ahead history tells us that at the core of its existence, humanity’s role is to deal with the problems at hand.

Among the challenges people have faced in history there has seldom been a way around the greatest problems but usually there is a way to get through them.

As investors we have been taught by experience that it’s in this process where the risks as well as the opportunities lie.

Looking at the month and the first half of the year just ended, investors’ patience—particularly stateside—was rewarded when markets rebounded from a downdraft at the start of the year and again after a reaction to the outcome of the British referendum that resulted in a vote for the UK to exit its more than 40-year membership in the EU (European Union).

Sensing a degree of irony we were reminded by the global markets’ reaction to the Brexit vote outcome that no country is an island in a globalized and highly digitalized world—even if geography points to the contrary.

As June neared a close global markets were roiled, and once again we recalled the Great Crisis of 2008, when the concept of regional de-coupling was debunked, as illustrated by trillions of dollars in market capitalization losses across the globe after the UK’s vote to Brexit the EU.

We think it’s important for investors to realize that market declines in the pricing of asset classes during such pullbacks are often experienced and limited as “paper” or “screen” losses as they are left unrealized by investors even though loudly bemoaned and lamented.

The rebound that followed the recent attentiongrabbing drop in equity prices around the world has given us reason to believe that the bark of the catalyst that caused the decline may indeed be worse than its bite.

With the first half of the year now complete, it’s clear to us that equity markets showed significant resilience through a particularly nasty seven-week stretch at the start of the year that was followed by a sizable rally (Feb. 11-April 20) that took markets to near new highs and then was tested via Brexit (June 23-27), which itself was followed by the rally from June 27th through last Friday’s close.

We expect that a testing of the rally is not unlikely as short-term investors look for a catalyst to justify some profit-taking at these market levels.

There had been enough market turbulence in the first half 2016 that we found some investors in meetings last week on the West Coast stateside who were pleasantly surprised when we showed them how well stocks had fared in the first half of 2016.

Stocks tracked by the S&P 500 (large-caps), the S&P 400 (mid-caps) and the S&P 600 (smallcaps) indices had respectively advanced 2.7%, 7.0% and 5.5% in the first half of 2016, and performed even better on a total return basis (with dividends re-invested), respectively producing returns of 3.8%, 7.9% and 6.2% in the period.
(Return calculations exclude applicable costs, including interest and commissions.)

Investors we spoke with were also surprised to hear that internationally emerging markets as tracked by the MSCI Emerging Markets index had advanced 5.03% in the first half of the year (and by 6.52% with dividends reinvested).

International developed markets (ex-US and Canada) as tracked by MSCI EAFE didn’t fare as well; the EAFE index experienced declines as Europe and Japan’s respective economic recoveries came under pressure and as a number of benchmark yields in those regions moved to near record lows—including some negative interest rates. The MSCI EAFE declined 6.3% (to produce a -4.04% total return with dividends reinvested) in the first half of the year.

All in all as tough as things had seemed at times while slogging through the first half of the year, stocks overall managed to show considerable resilience.

Economic data, though often mixed in the first half of the year, overall continued to show evidence of a sustainable stateside economic recovery as the consumer, who drives 70% of the US economy, benefited from continuing job growth, improvement in the housing sector, strength in auto sales and manufacturing (likely aided by the dollar’s easing off last year’s levels).

With the Fed’s dovish tone overtaking earlier hawkish observations by some of its members, lower interest rates for longer than were expected just a few months ago by Fed watchers are likely to provide further wind under consumers’ wings.

We continue to look for the S&P 500 to rally through its May 2015 record highs and reiterate our expectations for the broad market to cross the 2300 level before the end of the year.

We look for the dollar’s recent resurgence as a safe haven post the Brexit vote to moderate as UK and EU officials work to find a resolution in what will likely be a lengthier, more complex process of exiting than voters emerging from the polls on June 23rd might ever have expected.

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