Looking past scary headlines…resiliency

July saw markets collide with a whole bunch of unsettling headlines.

• Greece tiptoed across the default line.
• Stocks in China, which peaked in June, were badly battered in July.
• The Fed continues to telegraph that it wants to start raising interest rates sooner rather than later.
• Corporate profits are running into headwinds from the stronger dollar because overseas sales must be translated back into the more expensive dollar.
• And recently, we’ve watched the dollar flex its muscle again.
• Plus, commodity prices have resumed their downward slide. Thank the stronger greenback and nagging anxieties about Chinese growth, since China had been a voracious buyer of raw materials during the last decade.
• And the U.S. economy just can’t seem to reach escape velocity and breakout of its pattern of slow growth.

So how did U.S. stocks react last month?

On average, they posted a small gain. We’re treated to one unsettling headline after the other. It was enough for even the pickiest bear to get excited about; yet, July was a net positive.

*June 30, 2015 – July 31, 2015

**Annualized 

***USDSource: Wall Street Journal, MSCI.com

But let’s take a longer-term view than simply one month.

Some valuable perspective

”The financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher.” That quote came from Warren Buffett in a New York Times op-ed piece written in October 2008.

While stocks wouldn’t bottom for five more months, Buffet was quite clear. “Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts, the Depression, a dozen or so recessions and financial panics, oil shocks, a flu epidemic, and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.” It then went on to surpass 14,000 in 2007 and 18,000 late last year.

We subscribe to Buffett’s sentiment when he says he doesn’t “[have] the faintest idea as to whether stocks will be higher or lower a month — or a year — from now.” His longer-term approach is one that we are comfortable with.

Whether one jumped feet first into a diversified portfolio of stocks in 2000 or late 2007, investors who stayed calm and stuck with a disciplined approach may have gotten bruised, but they are ahead today.

As we’ve stated in the past, we tailor our recommendations to a number of variables. While we recommend a plan that puts you on the road to your financial goals, let’s do it in a way that allows you to sleep comfortably at night.

Bottom line – We don’t know when we will see the next 10% drop in the S&P 500 Index. No one does. It hasn’t happened in four years. But it will happen again. And I don’t know when we will see the next bear market, or one in which shares fall at least 20%. No one does. It hasn’t happened since 2008. But it will happen again.

A steep selloff in 1998 and 2011, both of which had their roots in the international economic crisis, gave way to renewed buying when fears subsided. Yes, it created anxieties at the time, but shares recovered.

If 200 years of history is a good guide; and we believe it is; a new bull market will emerge from the next bear market, which will propel stocks to another high. Patience really is a virtue.

Market pillars

Yes, shares are currently near an all-time high, and it can create volatility when short-term traders react to a negative headline. But when the negativity subsides, the more positive fundamentals reassert themselves.

While the U.S. expansion hasn’t been impressive, the economy is growing, and that puts a floor under corporate profits. Further, interest rates remain low and are expected to remain low even when the Federal Reserve gradually begins to boost rates.

In addition, companies continue to repurchase shares. Over the last four quarters ending March 31, 2015, companies bought back $538 billion of their stock, according to data from Standard & Poor’s. It’s the third highest four-quarter period of the economic recovery. This represents real demand for stocks while at the same time reducing the supply of shares available. What we would find concerning is a shift in the fundamentals. Most leading indicators, however, aren’t signaling an impending economic downturn.

About that all-time high

Now, let’s get back to the bull market and shares that are near an all-time high. Skeptics would argue that strong market performance since the economy left the recession leaves stocks in a vulnerable position.

Well, let’s look at the data between 1929 and 2013.

According to Bank of America Merrill Lynch, a 60%-100% rise in the S&P 500 Index over the past five years had absolutely no predictive value of how stocks would perform in the next 12 months. In other words, you might as well flip a coin when trying to predict where stocks might go over the next year after the S&P 500 Index racked up anywhere from a 60%-100% rise in the previous five years.

Again, it lines up with our philosophy that it’s almost impossible to predict how the market will perform over the next year. That’s why discipline and patience have historically rewarded the long-term investor.

Greece gets shutout in OT

Last month, the lion’s share of this newsletter focused on Greece. The prior bailout deal, which had an expiration date of June 30th, came and went without any agreement between Greece and its creditors. We were in uncharted territory, which created added uncertainty for investors. As we’ve emphasized repeatedly in the past, heightened uncertainty is an unwelcome companion for stocks.

The Greek prime minister surprised markets by calling a referendum on the agreement that European Union creditors had proposed at the end of June, and the Greek population shouted it down, with over 60% voting no.

But that did little to strengthen the hand of the Greek prime minister. When faced with a near disastrous default on its debt, the Greek government backed down and accepted a deal that was harsher than the one it rejected at the end of June.

It was clearly a bitter pill for Greece to swallow, especially as the austerity-weary nation has watched its unemployment rate soar above 25% and its Gross Domestic Product (GDP), which is the largest measure of goods and services for a nation’s economy, contract by more than 25% since 2008 (Eurostat).

In order to secure E86 billion for another bailout, Greece was forced to accept another round of austerity, but was unable to secure debt forgiveness.

While bankruptcy and debt forgiveness elicit all kinds of responses, Greece simply cannot repay the over E300 billion it owes to its creditors. And a recent survey of economists by Bloomberg reveals that most expect to hear from Greece again…probably next year.

It’s not that economic reforms aren’t needed; they are, and in a big way. But a reduced debt load, coupled with real reforms, would give the troubled nation some breathing room and a fighting chance to get back on its feet.

Bottom line; we will be revisiting Greece again.

China’s troubles

China’s stock market languished for much of the decade, but with encouragement from government officials, the retail investor in China jumped in, sending the Shanghai Composite Index up 152% from June 30, 2014 to its June 12, 2015 peak (FreeStockCharts data).

It’s a meteoric rise by any standards, with a buying frenzy fueled by margin debt. But the index quickly shed 32% of its value in less than one month, forcing the government to implement measures to stem the decline. For now, those measures have worked, but we’ve seen plenty of volatility in Chinese shares over the last month.

The concern – a continued decline in Chinese shares could rattle an already fragile financial system and send tremors in all directions. But perspective is in order. The U.S. exported $123 billion in goods to China last year (U.S. Census) but that compares to a U.S. economy that reaches nearly $18 trillion (U.S. Bureau of Economic Analysis).

While there are a few firms that depend on sales to China, overall revenues from S&P 500 companies amount to just 2% (based on most recent 10-K filings; FactSet, Compustat, Goldman Sachs Global Investment Research, Business Insider).

While we may see day-to-day volatility that originates from sharp moves in Chinese shares, keep your focus on the longer-term plan.

Looking ahead

The Federal Reserve continues to telegraph it wants to start raising interest rates this year. Historically, however, the start of a rate hike cycle by the Fed does not signal the end of the bull market. The first rate hike in the 1990s expansion stifled shares during the first year, but the bull market was just getting warmed up. Following the 2001 recession, the Fed implemented its first rate increase in 2004, three years prior to the market’s peak.

We’re still watching China, since it may create some instability going forward. While U.S. companies and the U.S. economy are not dependent on sales to the Asian giant, a recent quote from bond king Bill Gross sums it up well. China is “a riddle wrapped in a mystery, inside an enigma. It is the mystery meat of economic sandwiches – you never know what’s in there. Credit has expanded more rapidly in recent years than any major economy in history, a sure warning sign.”