Market ReviewSubmitted by Karstens Investments on August 2nd, 2016
By Michael D. Karstens, CFP®, AIFA®
What a strange year it has been. We could easily argue that we are in the midst of one of the strangest investment periods of all time. Politics, the European Union, interest rates etc. all seem to be turned upside down.
With the Republican Party narrowing the field from 17 candidates, none of whom anybody seemed to embrace, to one very polarizing candidate, and with the Democrats leading candidate narrowly beating out a self-proclaimed Socialist, it is likely that the rest of the year may be even stranger from a political standpoint. The chart below shows the sad fact that congressional approval ratings have fallen to close to 10%. I guess the good news is that close to 90% of the population can actually agree on something. The four months leading to the election will be interesting indeed.
On the interest rate side, the year began with very confident predictions of higher interest rates and up to four rate increases by the Federal Reserve.
The thought of higher interest rates now seems a distant memory. With 10-year Treasuries starting the year at 2.12%, the risk of higher rates had many believing bonds could be subject to losses, maybe even very large losses. Instead, for the first six months of the year, the 10-year bond gained 7.97% and the 30-year bond gained a whopping 16.93%. Virtually all of the gain stemmed from increased bond values due to falling rates and very little from the actual interest paid by the bonds. If U.S. rates seem crazy, just look overseas.
According to Bianco Research, $12.7 trillion of foreign government bonds now yield less than 0%. That’s over a third of the $35 trillion in outstanding total sovereign debt. Factor in another 41% of debt that yields 0% to 1% and you’ll see how crazy interest rates have become on a global basis. According to Sidney Homer and Richard Sylla in their book “A History of Interest Rates” today’s negative interest rates are a first dating back to 3000 BC! Bonds have basically been in a bull market (declining interest rates) for 35 years dating back to the interest rates peaks (remember 14, 15, 16% interest rates?) in the Reagan administration.
In Chart 2, you can see that rates have steadily fallen since 1982 after rising pretty much in a straight line in the prior 35 years. We would be on record calling this a bond market bubble. It’s hard to believe there are so many people willing to pay someone to hold their money in the form of bonds.
In Chart 3, you can see the dramatic effect this has had on savers. From 1986-1991, a $100,000 6-mo CD generated $6,000-$9,000 of income. From 1992-2001, a $100,000 6-mo CD provided $4,000-$6,000 of income. Today, the same $100,000 CD provides $370 per year of income. No wonder investors are stretching for yield.
From a stock perspective, the year began with the fear that a slowdown in Asia, especially China, would derail the global economy. Instead the big global shock came from the United Kingdom when, on June 23rd, they voted to leave the European Union.
Stocks immediately plunged around the world, only to subsequently rebound sharply. Clearly we have not seen the end of the Brexit story.
Stocks have truly been on a roller coaster ride the past 15 months. The market has been led by a small handful of strong performers and stocks that seemingly act like bonds. These include high dividend payers, utilities, etc., that have been snapped up by investors looking for yield wherever they can find it. This has driven these types of stocks to very high valuations which will likely suffer if and when interest rates rise.
As you can see in Chart 4, small and mid-cap stocks are down over the past 12 months while broad international markets are down close to double digits. Italy and Spain are both 35% off their all-time highs, while Germany and Japan are both down 25%. China is currently 40% below all-time highs. It’s hard to believe that cash, earning virtually zero, has been one of the best performers over the last 12 months.
One of the top performers over the last six months has been gold mining stocks. With the price of gold up 24.57%, the gold miners are up close to 90% nearly four times that of gold. Given the tremendous amount of global uncertainty and especially the global money printing being promoted by the central banks, the rise in gold probably is not all that surprising. With the unprecedented times that we are in, it is very difficult to predict what lies ahead.
Record low interest rates, excessive budget deficits and money printing by virtually all governments as well as rising social unrest have created a great deal of uncertainty. Stocks currently trade at high valuations compared to most historic valuations. The ultra-low interest rates certainly justify some of the over-valuations. If money printing continues and/or the economy and earnings accelerate, it is certainly possible that stocks could move higher. Valuations in emerging markets and some international markets seem somewhat more attractive and we wouldn’t be surprised to see some outperformance in those areas.
Gold continues to intrigue us as a potential hedge against money printing. We continue to avoid longer term bonds and prefer cash and high quality short term bonds as a safety net.