Second Quarter 2015 Forecast and Opinion

The focus of financial markets has now turned to sovereign debt as Greece heads toward default.
Several hours after the announcement of Greek capital controls, the Governor of Puerto Rico announced that
Puerto Rico’s $72 billion of debt “is unpayable”. Last week, Ukraine’s finance minister said that a default in that country is “theoretically possible”. The increasing likelihood of a chaotic “Grexit” is unsettling markets.

In order to keep interest rates low, the Federal Reserve has purchased over $3 trillion of U.S. bonds since 2008. The ECB has just begun its buying program, purchasing €52 billion of an intended €1.1 trillion of European bonds. Last June, the Bank of Japan became the biggest holder of Japan’s sovereign debt for the first time, with ¥201 trillion of holdings ($2 trillion), bypassing the amount held by domestic insurance companies. The Bank of England has purchased £375 billion ($571 billion) of Britain’s sovereign debt. All of this has been achieved with printed money.

The result of these policies have pushed bond prices to historic highs. In the U.S. and in Europe, they have hit the highest levels ever experienced in history. Current bond yields are the best predictor of bond returns, and the current yield on a 30 year treasury is only 3%. With U.S. inflation expected to be 2.1%, an investor would lock in a real, inflation adjusted return of less than one percent for the next 30 years. In Europe, that real return is negative. While there is little incentive to buy U.S. bonds, the Fed has finished its purchase program and the U.S. Treasury has huge (and increasing) borrowing needs. In fact, the U.S. Treasury projects that debt as a percentage of GDP will grow from its current level of 2.5% to an annual 4% over the next ten years. Decreasing demand and increased supply does not bode well for the bond market. Nor does an increasing lack of liquidity in that market as we head into summer.

As the Federal Reserve Board prepares for its next meeting it is considering raising short term interest rates. This will mean the end of the “easy money” policies which have driven the stock market since 2009. It’s interesting to note that margin debt on the NYSE reached historically high levels in April, usually a harbinger of a correction in stock prices. The U.S. market has not had a correction of more than 10% in over four years. It is also interesting that the biggest purchaser of stocks in the U.S. has become stock-issuing companies themselves. Record stock buybacks, fueled by corporate debt issuance, have resulted in net corporate debt levels reaching fresh all-time highs. As interest rates begin to rise, investors can expect these purchases to wane. The Dow Jones Transportation Index is often considered a leading indicator of where the market is headed. Although it is only one consideration in a broad picture, and is by no means perfectly accurate, the transportation index is now down 11% for 2015.

Yale professor and Nobel laureate Robert Shiller, has popularized the concept of a 10-year average of "real" (inflation-adjusted) earnings as the denominator of the P/E ratio. Shiller refers to this ratio as the Cyclically Adjusted Price Earnings Ratio, abbreviated as CAPE. The CAPE index is now at 26.6, while its historic average is 16.6. A variety of other valuation indicators also point to an overvalued stock market. The stock market faces many risks this summer: A higher than expected interest rate rise by the Fed, a Greek/Puerto Rican default, a continued slide in the bond markets, a chaotic Greek exit from the Euro followed by civil unrest, increased scrutiny of sovereign credit ratings, unforeseen geopolitical events (Syria, Iraq, Iran, Saudi Arabia, Ukraine), a slowing Chinese economy, and currency volatility. As for Europe, the upcoming Greek referendum will be decisive for the market. Any news that points to the Greeks cancelling the referendum will be met with enthusiasm; however if they proceed with the referendum the stock market may be in for a downturn. Either way, European solvency problems will not simply disappear. Un-competitiveness, poor labor mobility,
economies overweight in the public sector, high taxation, high labor costs, inflexible labor laws, generous entitlements,
low growth and high unemployment are all factors which should continue to weigh on the region.

For the first half of 2015, the Dow was down 1.1%, the S&P 500 was up 0.2%; and the Nasdaq was up 5.3%.

Grant Rogers

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