2nd Quarter 2015 Market Commentary

We are halfway through 2015. From this vantage point we can take what we learned from the first two quarters and speculate with perhaps a bit more certainty as to the economic trends of the rest of the year. In terms of performance the equity indexes mirrored their disappointing first quarter in returning negative to flat numbers. The Dow Jones Industrial Average closed the second quarter down -1.14% for the year. This negative first half return is the first such for the Dow since 2010. Similarly, the S&P 500 experienced a rough second quarter; it was negative from March through June and barely managed to post a weak mid-2015 return of .2%. Like the Dow, this is the S&P’s worst first half since 2010. The Nasdaq Composite, meanwhile, saw a decent 5.3% return through the first half, though this aberration of positive performance can be attributed to the heavy index weighting and exceptional growth of a certain Cupertino, California-based technology company. The Investor’s Business Daily Mutual Fund Index tracks strictly high-risk growth funds and was able to return 5.12%. Bonds experienced a counterproductive second quarter, with the Barclays Aggregate Bond Index dropping -1.68% for a negative year-to-date return of -.1%. With the six-year bull market showing signs of exhaustion we will examine below some of the economic data and events that could either rejuvenate or stop the bull in its tracks as we move into the latter half of 2015.

Domestic Developments

The second quarter American economy proceeded with neither vigor nor impotence, its uninspiring performance providing, at most, a refuge of stability in a time of fluctuating global markets. In line with the lackluster stock and bond market performance, several economic indicators—the crunched numbers we study to determine the health of the economy—show mild to negative growth characteristics. So while retail sales climbed high in May, preliminary reports show a subsequent decline for June. And while the housing market has shown signs of improvement, many millennials are eschewing home ownership in favor of renting, even in this time of historically low (but rising) mortgage rates. See too, below, for an examination of the dissonance embodied in the most recent employment numbers. Of course this is not to say the U.S. economic engine has stalled, it is merely to note the doldrums our six-year expansion seems to have entered into. Federal Reserve Chair Janet Yellen and the Federal Open Market Committee (the body that makes Fed interest rate decisions) are also undoubtedly parsing these reams of data in order to determine the timing and degree of their first promised interest rate raising. The previous prediction was for this rate change to have occurred in June. Now that June has come and gone the odds favor a September launch, though Chair Yellen has cautioned that, “Too much attention is placed on the timing of the first increase,” and not enough has been placed on, “the entire expected trajectory of policy.” In other words the timing is less important than the speed at which rates are hiked up. The Fed will likely raise rates before year end although Yellen’s June commentary evidences a seeming acknowledgement of the wobbly legs carrying the six year old bull market. The Federal Reserve has revised down its estimate for yearly gross domestic product growth for 2015, forecasting decidedly weak growth of between 1.8% and 2%.

International Developments

In contrast to our domestic economic stagnation the rest of the world experienced a turbulent first half that appears to be foreshadowing an even more turbulent second half. The continuing saga of Greece and the European Union commanded the most attention from investors. The Greeks owe a tremendous amount of debt to the European Central Bank (ECB), the International Monetary Fund (IMF), and other creditors whose loans have kept the small Mediterranean country on life support for the past five years. These creditors have imposed on Greece a host of so-called austerity measures that have culled some of the more egregious socialist bureaucracy and wanton spending. European leadership, particularly the German Chancellor Angela Merkel and her finance minister Wolfgang Schäuble, insist more austerity will be required for any sensible debt restructuring to take place. The Greeks have responded by electing the Marxist Syriza party and rejecting further calls for austerity. It is now a waiting game to see which side will blink first. Will Germany, Europe’s most productive economy, allow Greece to break away from the European Union and be forced to print its own currency? Or will Greece finally accede to comprehensive austerity measures and fundamentally alter the vast welfare state to which its citizens had become accustomed? Expect the can to be kicked several more times before any tentative resolution is reached. And although Greece has dominated headlines it is unlikely the standoff will have any significant effects on our economy.

Curiously, the international news that could actually impact the American markets received scant attention as compared with the big fat Greek debt crisis. This news is the bursting bubble of China’s stock market. From incredible highs mid-June—the Shanghai Composite was up over 100% in a year, and the Nasdaq-like Shenzhen ChiNext up over 150%—China’s indexes tumbled precipitously the following two weeks to end the quarter. Of course such steep heights were reached in substantial part thanks to government and central bank manipulation. In addition, unsophisticated Chinese investors flooded the exchanges with borrowed money (rampant “margin trading”) to get in on the red hot market, thereby pushing returns and prices even higher. So this burst bubble may just be a necessary and natural correction for an artificially overheated market. It also further demonstrates the strength and tenacity of the free market against even the technocratic machinations of China’s communist politburo. In any event, we will be watching this development closely in the coming months as any meaningful movement in the number two economy in the world—China’s stock market capitalization is $10 trillion—that very well may negatively impact the American markets.

Consumer Confidence

The confidence of the American consumer remains one of the more positive economic indicators even as markets languish. The University of Michigan Index of Consumer Sentiment for June was 96.1. This number trumps the non-recessionary year average of 87.4 and is up from the March reading of 93. Economists hope that this confidence will continue to translate into spending which will in turn boost gross domestic product and sustain our economic growth.

Gross Domestic Product

Just like last year the economy failed to hit the ground running in the first quarter. Gross domestic product (GDP) contracted -.2% to start 2015, underperforming even the most pessimistic growth estimates. This negative number marks the fifth time in as many years that the U.S. economy has failed to break over one percent growth for a quarter. Although consumers finally started to spend their extra money from gasoline savings, it wasn’t enough to offset the effects of a strong dollar and the drop in oil prices. The strong dollar has made American exports more expensive and has increased imports (imports detract from GDP), and the drop in oil prices has shrunk the previously booming domestic energy sector. The first advance estimate for the second quarter will be released July 30th. The new normal of middling growth, between 2% and 3%, is expected.

Employment/Labor Force Participation

The most recent figures released by the Department of Labor exhibit the persistence—highlighted in recent newsletters—of the anomaly of positive employment trends with contradictory underlying data. So politicians will tout 64 straight months of job growth and an employment rate that dropped in June to 5.3% without also explaining that the main reason the employment rate was down was because an incredible 432,000 people dropped out of the workforce. Wage growth was flat in June and the labor force participation rate (the percentage of able-bodied Americans actually working) fell yet again to a number not seen since 1977. The latest calculations show that just 62.2% of Americans who are able to work, are working. As the graph below demonstrates, the United States is the clear unfortunate outlier among its developed peers as it is the only country with a consistently declining LFP rate.

Economists have yet to identify exactly why this is happening. Some attribute it to demographic shift and to younger people foregoing work for prolonged higher education. However, it is undeniable (as has been shown by research economists at the Federal Reserve Bank of St. Louis) that the LFP rate is falling because prime age men and women (ages 25-54) are simply dropping out of the work force. This fact is hard to spin. The Federal Open Markets Committee will give close consideration to this conflicting labor market data as it decides the timing and speed of its inevitable nudging up of short term interest rates.

Technical Markets Overview

There are many ways to interpret the 200 day moving average. Often market technicians will make determinations based on the current price level of the S&P 500 index by comparing it to the average price of the index over the past 200 days. This interpretation of the 200 day moving average is called crossover analysis. The most recent price disruption in the markets based on the Greek debt crisis caused the S&P 500 index to dip below its 200 day moving average trend line. This crossover occurred for only one day, which may have led market analysts using a strict interpretation of the crossover method to move their portfolios into a cash position. The ensuing three trading days the S&P 500 rose approximately 3%, surging well above its 200 day moving average. This unfortunate circumstance is referred to as “whipsaw”. For this very reason the interpretation we choose to use is a slower moving trend identification analysis. We do not analyze whether the index’s current price is above or below the 200 day trend line, we analyze the 200 day trend line itself to determine overall market direction. Simply stated, today’s average price of the last 200 days must be less than yesterday’s average price of the past 200 days before the indicator would be considered negative.

This more moderate analytical process can delay moving into defensive positions and can also cause a more gradual reentry when emerging from a longer-term downtrend. Nevertheless, this process is much less susceptible to whipsaw scenarios such as the one that just occurred. We believe that oversensitivity to short- term stimuli in the market is not necessarily a good long-term barometer of the market’s direction. It appears the rate of increase in the 200 day moving average has begun to flatten, which confirms some of the negative data outlined above. And the sheer age of this bull market places it in the top three longest running, uninterrupted uptrends in history. Combine this age with the deceleration in the upward movement of the 200 day moving average and both may indicate we are coming to the end of the current bull market. Much more data will be needed to confirm this possible scenario but it goes without saying that markets simply do not rise forever.

Looking Forward

Our security markets have much to digest: the Greek economic crisis, the recent collapse in equity prices the Chinese stock market, and the impending nuclear agreement with Iran. Combine these macroeconomic and geopolitical events with conflicting domestic economic data and it is easy to see why our markets are without well-defined direction. As the markets gain greater clarity as these events continue to unfold its direction will become more apparent allowing us to chart a clear strategy in investment portfolios. Many portfolios allocate to money market accounts affording a buffer on declining days in the stock market while allowing us the flexibility to reenter the markets on any given day. We remain confident that the observational modeling process employed to manage portfolios may be helpful in both mitigating risk as well as participating in risk- appropriate investment options within portfolios.

Management/Investment Strategy

The portfolio management process used in identifying and making on-going investment choices to meet unique portfolio objectives, and which are consistent with particular risk profiles, includes the use of a sophisticated computer modeling system that analyzes price trends and other factors at various points in time.

It is important to understand that a model at any moment in time reflects all of its inputs. This is an observational process, not a predictive one. This means that models analyzed do not predict what the market will do, but rather simply observe what a market is doing and respond to it accordingly. Sufficient negative price movement may allow for a model to move into a defensive position and, correspondingly, sufficient upward price movement may trigger a movement toward increased exposure to the appreciating asset class. The adaptive nature of the modeling process helps to reduce risk/equity exposure in a portfolio as well as to respond to emerging up-trends in a way that potentially adds meaningful value to a portfolio. Of course, there is no investment process or strategy, or any computer modeling system that can eliminate losses or guarantee positive results. However, a computer modeling system properly used, is a valuable resource in both implementing and carrying out the risk management/portfolio strategy undertaken in the management of portfolios.

Performance Disclaimer

No investment strategy or methodology can guarantee profits or protect against losses. Investment risk includes the uncertainty and volatility of potential returns for a portfolio or an individual investment over time. Investment risk is inherent in every individual portfolio and no computer model or modeling program used or relied upon in making investment choices for a portfolio can eliminate risk. A computer modeling program may not reflect actual risk and return parameters applicable to any particular portfolio or investor.

Actual investment decisions made on the basis of a computer generated model or modeling program may be materially different from expected or intended results, and any computer modeling program is subject to errors in the program and system failures at any time.

THE WESTERMAN GROUP, LLC is a Registered Investment Advisor Securities offered through MerCap Securities, LLC Member FINRA/SIPC Office of Supervisory Jurisdiction 40 Darby Rd., Paoli, PA, 19301 (877) 784-8021 The Westerman Group, LLC and MerCap Securities, LLC are not affiliated.


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http://www.bls.gov (employment data)

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