Download July 24, 2016 - Stearns Financial Group

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
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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).
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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)
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