Through a Glass, Darkly: Q1 to Q2

April 3, 2015

Q1? On the books. Large cap equities finished the quarter flat. Up 0.60 percent year to date. Small- and mid-cap stocks fared much better. Finishing the quarter 3.27 to 8 percent higher, respectively. Q1 also saw foreign stocks improve. The MSCI EAFE foreign index jumped over 6 percent.
Since last July, the S&P 500 has remained range bound. Bouncing between 2000 and 2117. A variety of offsetting forces, some of which remain murky, some of which are quite clear, have begun to exert opposing forces on asset classes. Leading them to behave in manners disparate from those which they've followed these last few years.
Most impactful among them? Interest rates. Increasingly, it appears that the Fed may push off its once alleged June rate hike until December. Or later. For as the jobs market appears to be strengthening, it is simultaneously exhibiting characteristics that exude weakness. Leaving the Fed to second guess the need for a summer hike. Which could damage the nascent recovery. Of course, this recovery has been deemed nascent for six years. But that's another topic.

Q1 saw any number of crosswinds both propelling and prohibiting investment assets. The strong dollar. The Dow's first close above 18k. Terrorism in Paris. The Swiss National Bank's currency move. ECB bond buying. Left wing victory in Greece. Radio Shack's bankruptcy. Apple's first-ever $700B market cap. President Obama's veto of Keystone XL pipeline. Nasdaq's return to 5k. Netanyahu's White House-defying Congressional speech. Continuing M&A activity. Apple's move to the Dow. Kraft's marriage to Heinz at the altar of Buffett. Among others.
The year's initial three months saw markets vigorously furrowing through two events. Both of which continue into Q2.
The first? The energy sector's volatility following the abrupt and continuing decline in oil prices. Certain oil types are 50 percent cheaper than this time last year. We expect prices to remain low, perhaps fall further. Though we believe prices will strengthen as oversupply organically tightens in Q3 or Q4.
The second issue emanates from the European continent. Particularly the European Central Bank (ECB), which has stewarded interest rates into negative territory at minus 20 basis points. The ECB plans to acquire the sovereign debt of Eurozone nations as part of its U.S.-style quantitative easing (QE) program. Lots of it.
These negative rates will have a global impact, as they will suppress rates elsewhere. Including here in the U.S. The outlook? ECB policy will continue through most (if not all) of 2016. Likely keeping a lid on global interest rates.
The beneficiary of these crosswinds will be U.S. stocks. Save for those in the energy sector. Which will continue putting a little pep in the step of equity bulls. A steady diet of low interest rates, low inflation and a laggardly economic improvement is bullish for most asset prices. Particularly stocks.
However, while we remain bullish on large cap U.S. equities, we believe that foreign stocks -- particularly those in Europe--will garner significant attention. Deservedly so. Moreover, small cap U.S. stocks as measured by the Russell 2000 index have returned over 6 percent this year. Mid caps have lathered up investors with an 8 percent gain. While the S&P 500 returned a piddling one percent. Accordingly, we continue to position portfolios for greater international, small- and mid-cap exposure. Which we believe will represent this year's sources of outperformance.
Can U.S. equities regain their swagger in Q2? Perhaps. Of course, what goes up must come down. Moreover, Newton's First Law of Motion teaches that an object in motion stays in motion. Until, that is, it's acted upon by an opposing, unbalanced force. Or, perhaps these two physical principles simply offset one another.
Fact is, many investors worry that the market's upward trajectory will be stultified by the dollar's new found stature. And so U.S. exporters and investors hope for the emergence of an unbalanced force. Because the U.S. dollar has risen Phoenix-like. Jumping 20 percent in 12 months. Great news if you plan to travel overseas. Or if you own dollar futures. Not so if you're exporting goods and services.
The media has kicked off the second quarter by hitching its advertising-money machine to the rising dollar. Packing it squarely within its Pandora's Box du jour. Replete with the Iranian nuke deal. Global Terrorism. Civil and racial unrest. And now the ramifications of a rising dollar.
Fire! Ready. Aim. Eh?
At first glance, one might take the bait. Buy into the narrative that a rising dollar diminishes Q2 market-return expectations. If not the entire year.
To begin, the dollar's appreciation impacts exporters. Cincinnati's Procter & Gamble? Extremely dollar sensitive. Pantene. Gillette razors. Crest toothpaste. All sold to global consumers. As the dollar rises in value, these products become more expensive for foreign consumers. Accordingly, European buyers increasingly opt for less expensive brands.
Adding insult to injury? The idea that P&G's diminished foreign revenues suffer further when profits are repatriated from a falling euro to a rising dollar. That is, the company sells less. And revenues earned are less profitable.
Not an ideal tandem.
Considering that P&G incurs 67 percent of revenue overseas? One begins to understand the dilemma. P&G recently bolstered the narrative. Telling analysts sales will likely fall five percent. Profits will drop by 12 percent. Nor is Procter & Gamble alone.
McDonald's. Microsoft. United Technologies. Dupont. Pfizer. Qualcomm. Texas Instruments. A sampling of American corporations that the talking heads prognosticate will be impacted--if not drawn and quartered--by the dollar's new-found swagger. Even more disconcerting? Consider that fifty percent of the S&P 500's earnings occur outside the U.S.
Surely, one comes to believe, this signifies the other shoe. The last straw. The camel's broken back. The beginning of the end. Sell everything. Batten down the hatches. The end is nigh!
The strong dollar will kill U.S. exports. Crush earnings. Send stocks plunging.
Of course, talking heads don't make a living by offering false hope. But by proffering no hope at all.
Perhaps you're one of those nuts who don't simply swallow the hook, line and sinker. Perhaps you actually consider the historical precedents. In which case, you already have found solace in the idea that you need not RSVP for this particular apocalypse.
Historically, a big-12-month move in the buck has been positive for stocks. While the 20-percent currency move is one of the largest we've seen, a little analysis reveals that similar historic dollar increases of 10 percent or more have occurred only 14 percent of the time since 1971. Each of which sent stocks plummeting, right?

Counter intuitively, stocks jumped by 10 percent a year following these historic dollar moves. Since 1971, the standard one-year return for stocks was 7.2 percent. Meaning that stocks have actually fared better following periods when the dollar soared. Which tells us that stocks could defy today's conventional wisdom and outperform in the coming year.

Small caps. Mid caps. Foreign equities. And finally, large cap U.S. stocks. In that order. Too many tailwinds to derail these locomotives now.
Six months ago, talking heads served up Ebola. Prior to that, it was racial injustice. Campus rape. Rising interest rates. Or perhaps some trumped up weather pattern that eventually moistened your lawn, as opposed to razing your home.
At some point, contrarians learn to push aside mainstream cynicism. So allowing room to think for themselves. Of course, when moving large objects, the trick is to exhale coincident with undertaking the big push, versus holdings one's breath and thereby increasing the pressure exerted on the lung and risking its collapse. Accordingly, such effort does not come easy. We must endeavor greatly towards such thinking. Though the reward justifies the effort.
The second quarter finds us looking through a window, darkly. Confounded by the caterwauling. The signal and the noise. Yet, those variables that propelled us here do, in fact, remain in place. Enabling contrarians who can withstand the omnipresent mainstream onslaught an opportunity at continuing profits. Be they financial, psychological, social or spiritual.

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