Second Quarter 2015 Commentary

Breaking News From 2010

Some things just never seem to change.  The recent weeks of volatility that have given us triple digit moves in the Dow Industrial Average have been exclusively driven by worries over Greek debt and the cohesion of the European monetary union.  That last sentence could have lead off our market commentary in 2009, 2010, 2011 or 2014.  Not only has Greece not dealt with their systemic deficit problems, but the EU can’t seem to come to terms with the fact that Greece won’t get its fiscal house in order. 

The recent stock market downturn in the U.S has been in response/sympathy to the broad market declines in Europe.  Euro zone markets have experienced sharp declines as the European Central Bank and IMF have been unsuccessful at negotiating repayment terms for the outstanding Greek debt.  Greece was due to make a substantial loan payment ($1.73b) to the IMF at the end of June, but of course didn’t have the funds necessary to fulfill that obligation.   In addition, Greece is running out of cash to meet its current payables.  Without further outside financial support, Greece will have no choice but to leave the European Union so it can reintroduce its own currency.  The Drachma may not be worth much, but at least they could print as much as they’d like.

In our opinion, a Greek exit is inevitable.  There surely has to be a point where the Germans will tire of bankrolling the Greeks.  It seems that most market participants are now coming to terms with that conclusion as well.  The larger question is the same as it has been for years - what will that mean for other weak European Union members?  This larger question is what’s really driving the current market fears. 

While that question is legitimate, we feel the current market reaction is entirely overblown.  There are significant differences today than there were five years ago.  Most notably, the European banking sector is in much better shape than it was in 2009.  Back then, Greek and other questionable sovereign debt was held throughout European banks and posed a real threat to their capital levels.  Years later, that debt, and Greek debt in particular, is held with the ECB.  The risk to the EU banking system doesn’t exist like it did in the past. 

For this reason, we believe this latest downturn will pass in the coming months.  If that were to be the case, we should see stock prices stabilize at their April levels.  Even then, that would only put the S&P 500 up 2.5-3% (before dividends) for the year.  As modest as those returns are, it would be in keeping with our expectations at the beginning of the year.  At that time, we felt that 2015 would finish with upper single digit returns with much of those gains occurring in the last quarter.

The U.S. stock market has strung together several consecutive years of gains (albeit from very depressed levels) and was in need of a pullback due to the valuations.  This year was likely to be the year earnings would need to catch up to stock prices.  The greatest impediment to that scenario was the strengthening dollar relative to the Euro.  Europe is our second largest export market so a stronger dollar makes our goods more expensive in their currency.  This then negatively translates into many U.S. companies’ earnings.

Depending on the day you’re reading this, to date the U.S. stock markets are largely flat.  Unlike last year, the mid and small cap sector of the stock market has performed better than the S&P 500.  The NASDAQ index has also out-performed large cap stocks.  Still these gains are modest at best. 

One other unknown hanging over the stock market is when will the Fed begin to raise rates?  They have stated that their preference is to start the process sooner than later.  At this point, the consensus is, barring any European contagion, it will be this fall.  Generally rate hikes are bad for the stock market, but this expectation has been built into the market for a while.  Higher rates will also be a needed relief for investors seeking income.  There’s a long way to go before we see anything that looks like normal interest rates, but we need to begin that move very soon.

In conclusion, while the Greek news had a big impact on the past quarter’s performance, ultimately we don’t think it will have led to anything by the end of the year.  Once there is a better understanding of the stronger dollar’s impact on GDP, we’ll probably see the Fed enact their first rate hike since the financial crisis began years ago.