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UPDATE ON THE ECONOMY & INVESTMENT MARKETS Welcome to the Stearns Financial Poolside Chat. The rally in U.S. and overseas stocks shouldn’t come as a big surprise. The S&P 500 stock index had gone 413 days without a new one-year high. According to Ned Davis Research, that was the 19th longest stretch in the S&P 500’s history. Over the last 60 years, betting against the future of the majority of the largest companies in the U.S. has been a losing proposition over 80% of the time. What was the catalyst for this summer rally that led to new highs in the U.S. stock market? One strong catalyst was the Citigroup Economic Surprise Index (CESI), which moved into positive readings following a batch of “surprisingly positive” (at least to the consensus of industry analysts) economic news in the last several weeks. Some of these positive developments were discussed in our last Poolside Chat. The CESI measures whether economic data is coming in better or worse than expectations. It does not measure the absolute level of growth, although indications are lining up that the back half of 2016 and 2017 will see higher growth in the U.S. than we’ve been used to in the last five years. Source: Schwab, FactSet, as of July 15, 2016 This is an important distinction. Many investments do better when expectations are low and surprises are positive. Set the expectation bar too high and the same exact economic news or stock earnings report results in a loss instead of a gain! Such is the short term “voting machine” psychology of investment markets. The longer term “weighing machine” reality is much more logically grounded, and usually depends on whether investments have positive future earnings prospects and are priced as bargains, fairly priced or overpriced. Recent economic news that was better than expected includes: Industrial production was up 0.6% in June vs. 0.3% consensus Retail sales were up 0.6% in June vs. 0.1% consensus Initial unemployment claims declined to 254k as of July 14 vs. 265k consensus NFIB small business optimism index up to 94.5 in June vs. 93.9 consensus 24 | July | 2016 Page | 1 Payrolls were up 287k in June vs. the 180k consensus The ISM Non-Manufacturing index rose to 56.5 in June vs. 53.3 consensus The ISM Manufacturing index rose to 53.2 in June vs. 51.3 consensus Many of the above economic indicators, including jobless claims and the ISM readings, are leading indicators, meaning they are predictive of better economic news in other areas in the coming 6-12 months. Bespoke research notes that “In all the previous times when the S&P 500 has made a new alltime high, following at least 52 weeks below the old high water mark, the average return over the next 12 months has been 12.28% (median +12.30%) with an average pullback of 5.48% (median 2.73%).” Those who are waiting for a 20% pullback in stocks in the near-term in order to buy at better prices are likely to be disappointed unless there is some big negative surprise that creates a more intense “risk off” investor mood. SFG’s take: The latest surge in U.S. stocks and other investments are a result of relative positive surprises in the economy and earnings, as well as low interest rates driving yield hungry investors to pay more attention to yield than risk. Most of the time, stocks look ahead 6-9 months – the latest bull market surge appears to be starting to price in a year ahead of positive company earnings and economic news, with continued low interest rates and perhaps only 2-3 Fed interest rate hikes. SFG remains cautious as both valuations and bullish sentiment move higher. We will continue to make adjustments in investment allocations reflecting our view of risk vs reward in various investment areas. Key Point to Consider Since Brexit, investors have been pouring money into higher risk bond funds. Over $4 billion has collectively been added in the last three weeks to high risk exchange traded bond funds that invest in more speculative U.S. and overseas bonds. These funds are enticing with yields in the 4-6% range. However, scenario modeling suggests the odds favor these funds losing principal value that would erase some or all of the returns from the higher yield. A rising number of scenarios have these funds earning zero or even negative total returns in the coming 3-5 years. Yet another reason for caution. Frequently Asked Question Q: What are some key scenario drivers that would cause you to become significantly more cautious in your investment allocations? A: Following the KISS principal, here are five key areas where negative shifts could cause a shift in our allocation strategy, with our view on the current state of each one: 1) Prospects for a recession (not likely in the U.S. in the next 12 months), 2) Expensive valuations (getting stretched in some bond, stock and real estate areas, but debate is whether valuations are truly “expensive” given the low interest rate environment and prospects for very gradual interest rate increases in the next few years), 3) Accelerating inflation, or problematic inflation (tightening labor market bears watching, but inflation is mostly under control), 4) Hostile Federal Reserve (the Fed hasn’t yet taken the punch bowl away from the party – see the important “Only Game in Town” article in our upcoming SFG Trends newsletter) and, 5) Investor exuberance (rising bullishness, but far from exuberant based on the latest Ned Davis and AAII surveys). 24 | July | 2016 Page | 2 Summary Instead of focusing on the “mis-direction” of the Brexit drama, there are a number of reasons to believe the 12-month outlook for the U.S. and many overseas economies is relatively stable. We remain moderately positive in the next 12 months about the U.S. economy and neutral on overseas economies. We remain neutral and cautious about most asset classes in the U.S. and overseas. ~ Dennis, Glenn, Jim, John and PJ (the SFG Investment Committee) 24 | July | 2016 Page | 3