ECONOMIC AND MARKET REVIEW JUNE 2014

Merger and acquisition activity picked up significantly, leading to a “buy on the dips” strategy by investors.

U. S. financial markets marched higher in the second quarter, with most equity indices closing at all-time highs. Encouragingly, the rally broadened, with growth and smaller cap stocks bouncing back after lagging earlier in the year. Federal Reserve officials reassured investors there is still too much slack in the labor market to think about raising interest rates until the second half of next year. Indeed, only three out of the nine indicators in Chair Janet Yellen’s “dashboard” of jobs data are back to prerecession levels, with average hourly wage growth still anemic at around 2.0%. Meanwhile, first quarter earnings reported in April were above recently lowered, weather related expectations. Merger and acquisition activity picked up significantly, leading to a “buy on the dips” strategy by investors.

Bond prices rose and continued to confound the consensus, with yields on 10 year Treasuries moving lower from 2.72% to Cartoon bank2.53%. One explanation is that U.S. bonds became relatively attractive after Eurozone bond yields fell in anticipation of further European Central Bank (ECB) easing in June. To be sure, yield spreads from Spanish and Italian bond spreads ended June at only 12 and 31 basis points (0.12% and 0.31%) over Treasuries. At some point, however, the effects of a strengthening American economy will overcome the relative yield play, and rates should begin to creep up again to the 2.80% to 3.00% range.

After posting a worse than expected contraction due to extreme winter weather in parts of the country, the economy is rebounding, with three month average payroll growth of 272,000 jobs finally above its 2007 peak. Moreover, vehicle sales are trending at almost a 17 million annual rate, the highest since 2006, and small business hiring and borrowing are on the rise. Another pleasant surprise is the consistently shrinking federal budget deficit, which has benefitted from an economic expansion now starting its sixth year.

However, foreign market returns again were mixed, with a standout being India given the election of pro-business Prime Minister Narendra Modi. Japan also did well, while China continued to meander. Most European markets rallied ahead of ECB President Draghi’s latest monetary stimulus package but have since pulled back, on a “buy on the rumor, sell on the news” reaction. Our investment thesis of favoring developed over emerging markets continues, especially with a tightening global monetary cycle approaching.

Domestic stocks are not cheap, but are not expensive either, with the S&P’s forward price-to-earnings multiple around 15.5. There are few investment alternatives, especially with bond yields so low. Meanwhile, the economy and the market continue to edge upward and the investing public, especially the retail investor, has not embraced this bull market yet. Until this occurs and stocks reach overvalued levels, they will remain the investment of choice.