U.S. economic data

The attainment of yet another new all-time high by the S&P 500 Stock Index last week has elevated the voices of long-time bears calling for a painful market correction. They cite lackluster U.S. economic data, high valuations, the onset of tighter monetary policy, and the lengthy 3.5 year period since the stock market suffered more than a 10% decline (last October’s swoon was stopped at 9.9%). In short, have the rewards generated by the "buy-the-dip" strategy caused investors to lose sight of the risks of a much larger correction?

While the S&P 500’s over 200 percent gain since the bottom in March 2009 has restored the wealth of many U.S. equity investors, skepticism about the strength and sustainability of the rise remains. It took until March 2013 for the stock market to regain its old high set back in 2007, dealing investors nearly a 50% decline along the way. Further back, investors getting into stocks in early 2000 waited nearly seven years for the market to recover the painful losses after the tech bubble burst. Although these periods are fading into the rear view mirror, the depth of the decline will remain burned into investors’ memories, at least until a new younger class of buyer emerges.

Fund flow data reflects investor skepticism on stocks. Despite the relatively steady climb of the U.S. stock market since 2009, equity mutual fund flows have been modest. Between 2009 and 2013, equity mutual funds suffered large outflows while most new money went into bond funds, despite paltry yields. Even after the strong bull market of the last six years, stock mutual funds have suffered a net outflow of approximately $6.7 billion per month over the last 12 months, while bond fund flows have been positive. When including the explosive growth in demand for Exchange Traded Funds (ETFs), the numbers look better, but the overall trend still reflects a high degree of caution. Surveys of investor sentiment reflect an unusually high percentage of people who declare themselves neutral, neither bullish nor bearish.

Investors appear puzzled by the fact that the U.S. stock market has been able to avoid a significant decline this year despite a weak first quarter GDP (likely to go even lower after upcoming revisions), the damaging effect of the strong U.S. dollar on U.S. multinational earnings, and the failure so far of the economy to exhibit the rebound in the second quarter that many have expected. Yet many people forget the market’s role as a forecasting mechanism. Despite the disappointing trends in the current data, confidence remains high that the future looks better, and that is what keeps the market on an upward path. We see the key drivers of the economy – job growth, consumer spending, and low interest rates – as remaining stable or getting better in the next few quarters. With signs of a turnaround emerging in Europe, the next recession still looks to be well into the future.

A healthy skepticism is a necessary part of successful investing, and complacency is its enemy. When the crowd thinks that the only direction is up, it is prudent to consider other scenarios. In this case, however, we believe investors are appropriately assessing the risks, and we continue to find value in stocks.

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