After an early-year pause, most categories of financial investments provided solid returns during the April-June quarter. Blue-chip U.S. stocks recorded a three-month return of around 5%; gains in overseas markets varied, but on average were about in-line with those in the U.S. Most real-estate securities notched relatively strong returns, while commodity-related securities lagged; gold gained about 3%. Bond yields surprised almost everyone by drifting lower (the 10-year U.S. Treasury Note finished at 2.52%, compared to 2.72% at the end of March); credit spreads continued to narrow, allowing fixed-income investments to post solidly positive three-month returns.

Within the U.S. market, the strongest results came from companies in the Energy, Basic Materials and Technology sectors; underperforming groups included Consumer Cyclicals, Consumer Staples and Financial Services. Returns from small-company stocks trailed those of large-caps; growth-oriented names outperformed those in the value category.


Benchmark Performance – Equities


Second Quarter 2014

Last Twelve Months

S&P 500 Index



Large-Cap. Core Mutual Fund Avg. (Morningstar)



 Small-Cap Stocks (Russell 2000)



 Non-U.S. Stocks (Developed – MSCI EAFE)



 Non-U.S. Stocks (Emerging – MSCI EM)




Benchmark Performance – Fixed Income

Second Quarter 2014

Last Twelve Months

 Barclays Intermediate Gov’t/Credit Index (taxable)



 Intermediate Municipal Mutual Fund Avg. (Lipper)





The April-June period saw most financial assets resume a healthy rate of appreciation, despite sluggish economic growth and a flare-up of geopolitical risk. The current Bull Market marked its fifth birthday earlier this year, with the cumulative return on U.S. stocks approaching +200%. In contrast to the first two-and-a-half years of the rally – a start-and-stop period characterized by recurring crises and high volatility – the advance since late 2011 has seen steady and accelerating gains accompanied by decreasing volatility. From April 2009 through November 2011, U.S. stocks recorded a net gain of roughly +40% and experienced ‘corrections’ of -19%, -16% and -10%; since November 2011, appreciation has been nearly +75% without a single decline of -10% or more. Low volatility continued in the April-June period, which saw the S&P 500 Index record just four one-day price changes (up or down) of more than one percentage point (and all of these came prior to April 16th); at no point during the quarter did the index fall more than 4% below an earlier closing level.

Global bond yields have confounded the vast majority of observers this year by falling from already-depressed late-2013 levels. The surprising result seems to reflect a combination of very low (and in Europe, declining) inflation, disappointing economic growth (especially in the U.S.) and successful efforts by global central bankers to provide ‘forward guidance’ indicating their preference for lower long-term yields in support of stronger growth. Low volatility extended to fixed-income markets: 10-year U.S. Treasury Notes traded in a range of just 35 basis points (0.35 percentage points) the entire period.

Domestic economic news was dominated by the surprisingly weak accounting of first-quarter (January-March) growth, which was repeatedly revised lower to an eventual annualized rate of -2.9% – by far the worst showing since the recession of 2008-2009. Although severe winter weather had much to do with this result, the weakness turned out to be more widespread than we believed when we wrote to you in April. Coincident and forward-looking data reported during the second quarter, however, painted an improving picture: purchasing managers’ surveys, sales of new cars and trucks, and monthly payroll gains were all upbeat, while consumer and small-business confidence both reached new post-recession highs. A particularly welcome development was a rebound in pending sales of existing single-family homes, which hit an eight-month high in May, handily exceeding expectations.


What’s Changed?

To provide insight regarding recent stock market performance, we can deconstruct the three-month return from stocks into three components:

1)         Dividend Income (for three months this is the annual yield divided by four)

2)         +/- Change in Earnings per Share* (average for S&P 500 companies)

3)         +/- Change in Valuation (Price/Earnings Ratio)

= Total Return


            * based on forecast earnings for next 12 months (Source: S&P Outlook)


So, what changed during the recent quarter to give us the +5.2% S&P 500 total return?

Second Quarter (April-June) 2014
Dividend Income +0.5% +5.2%
+ Change in Earnings +4.1%
+ Change in Valuation +0.6%
= Total Return +5.2%


Our read: One of the better earnings increases we’ve seen in a while, largely justifying the market’s solid three-month return.

Overseas developments were a mixed bag. First-quarter Eurozone growth underwhelmed at just +0.2% (quarter-over-quarter), with strength in Germany and peripheral economies insufficient to offset weakness in France, Spain, Italy and the Netherlands. Deflation remains a distinct worry on the Continent; the European Central Bank – which cut short-term rates and instituted a negative interest rate on bank reserves late in the quarter – is widely expected to take further stimulus measures in months ahead. Conversely, the British economy grew strongly; signs of a housing bubble caused Bank of England governor Mark Carney to hint that rate increases may be nearer than markets expect. Meanwhile, the Japanese economy continued to expand despite its April value-added-tax increase, a hopeful sign as Abenomics enters its third year. In emerging-market news, national elections in serial-underperformer India installed a new pro-business/pro-reform government; stock investors cheered. Statistics from China showed a distinct cooling of a previously frothy property market, but suggested the overall economy was stabilizing after another early-year ‘hard-landing’ scare.

On an unusually busy geopolitical front, the surreal standoff in Ukraine continued to ebb and flow: Russia’s endorsement of Ukraine’s late-May elections was a huge step in the right direction, while violence in eastern Ukraine continued and even intensified through June. In Asia, territorial tensions continued to simmer among a newly assertive China and a number of its neighbors (particularly Vietnam). Most worrisome was the eruption of violence in Iraq, where the sudden emergence of the Islamic State of Iraq and Syria (ISIS) insurgency caught most observers off-guard. While it is too early to gauge the impact of this latest crisis, we note that Iraq is the second-largest OPEC oil exporter, so any threat to the flow of oil would likely cause an unwelcome jump in energy prices (the price of oil rose marginally during the period).

Profits reported by S&P 500 constituent companies during the second quarter (generally covering January through March) were about 6% higher than a year earlier, bringing the trailing-twelve-month gain to a little under 11%. Wall Street analysts expect earnings growth to accelerate marginally – to around 13% – over the remainder of the year.



As we have noted before, the remarkable performance of most financial assets over the past two-plus years has been founded on receding ‘tail’ risks (think: Euro Zone meltdown; U.S. debt default), record-high profits, and persistently (as well as surprisingly) low interest rates. The gains have also been underpinned by a low (cheap) level of valuation and a high degree of investor skepticism (or fear; the opposite of greed), especially during the early stages of the rally. Developments that threaten any of these props could undermine the markets going forward; below we examine each in turn.

Risk. At the 100th anniversary of the start of the First World War, it seems fitting that economic and financial-market risks seem lately to have been supplanted by rising geopolitical tensions. In our last letter we worried that Russia’s actions vis a vis Ukraine could usher in a new, less benign post-Post Cold War era. Similarly worrisome: more than one historian has noted parallels between today’s rising China and early-twentieth-century Germany, while Japan’s recent ‘reinterpretation’ of a key article of its pacifist constitution is another eyebrow-raising development. Meanwhile, developments in the Middle East – from the ‘Arab Spring’ to the Syrian civil war and the rise of ISIS – could mark the beginning of the end of the system devised by the First World War’s victors to deal with the vanquished Ottoman Empire; what would take its place is far from certain. While none of these areas of concern seems likely to cause an acute crisis in coming months, their combined effect on global economies and financial markets seems bound to be negative.

Earnings. As noted, profits are high, fueled by moderate economic (and thus revenue) growth, coupled with a major expansion of margins, over the past five years. Margins are historically ‘mean-reverting,’ suggesting that a decline from today’s level is statistically likely (not to say inevitable). Even if a contraction is not in store, it seems unreasonable to expect substantial further expansion. As for revenues, after a roughly flat first half, domestic growth for all of 2014 seems certain to fall short of early-year expectations – which called for real growth of around 3% (plus ~2% inflation equals ~5% revenue growth). Growth in many export markets is anemic and uncertain, particularly continental Europe, which remains the most important foreign market for many large U.S. companies. And though the current read on China is relatively upbeat, a renewed slow-down remains a possibility, with implications for much of Asia. The threat of an ISIS-induced spike in energy prices further clouds the growth outlook. In sum, an optimistic scenario points to mid-single-digit earnings gains, and a less-rosy case can easily be made; conversely, it is difficult to see how near-term earnings could be much stronger than currently anticipated.

Rates. On the heels of a dismal first-quarter, recent indicators of both real growth and inflation in the U.S. have been ticking up. If second-half growth averages around 3% (which seems plausible) and inflation gauges hold steady or continue to rise, the Federal Reserve is likely to begin in earnest the process of ‘normalizing’ (i.e., raising) short-term interest rates sometime next year. Depending on the tenor of incoming data, we believe this process could begin sooner and/or progress faster than many market participants currently anticipate, which could result in some volatility in longer-term yields (perhaps similar to the mid-2013 jump in yields when then-Fed-Chair Bernanke first hinted at what would later become the ‘taper’ of quantitative-easing). In any case, we have often noted over the past several years that the Fed’s ‘unwinding’ process would be fraught, so we shouldn’t be too sanguine as it begins.

Valuation. Although the market’s second-quarter gain was about equal to the increase in earnings (see ‘What’s Changed?’ box above), since 2011 price-appreciation has greatly exceeded profit growth, resulting in a substantial rise in the valuation of U.S. stocks. At June 30th, the S&P500 Index was trading at more than 18 times trailing (i.e., already reported) earnings, and about 16 times profits expected for the year ahead; both figures are 10% or so above historical averages. Another often-cited measure of valuation is the ‘cyclically-adjusted price-earnings’ ratio, which averages earnings over a ten year period to smooth-out the highs and lows associated with the business cycle; that measure shows U.S. stocks somewhat more expensive compared to average. History shows that high valuation can persist for years, especially when, as currently, inflation and interest rates are low. Nor is high valuation, per se, likely to precipitate a market downturn. But it is statistically true that higher beginning valuation tends to reduce prospective returns, suggesting the potential upside (reward) to owning stocks is less today than it was two or three years ago.

Sentiment. While sometimes difficult for non-professional investors to fathom, in general it is good when market participants are worried and/or pessimistic: an old Wall Street adage holds that the market ‘climbs a wall of worry.’ Another way to think of this: when nearly everyone is enamored of stocks, most have already bought all they can, leaving little fuel for additional gains. For much of the current Bull Market, sentiment measures indicated that investors were extremely skeptical; it has been called the most distrusted Bull Market in memory. That has clearly begun to change. Direct survey measures of sentiment, particularly among professional investors, are nearing levels of complacency not seen since 2007 (though they are still far short of the exuberance of the late 1990s). Low volatility is another indication that worry is on the wane; after all, they call the VIX the ‘fear index.’ Like high valuation, heightened investor complacency and greed are insufficient to cause a market downturn – but they are generally important prerequisites.

Every Monday afternoon, Oarsman Capital’s investment committee convenes to discuss recent developments that might change our views regarding the attractiveness of various investments. The discussion focuses on a number of specific data we feel have a good track record of ‘taking the temperature’ of the markets and providing early warning of impending trouble. It is noteworthy that this process has not recently revealed any flashing-yellow signals; in fact, the readings have been as positive as at any time during the current Bull Market – leading us to our overall constructive assessment of the markets. Nevertheless, our analysis of the market-driving factors discussed above suggests that the reward/risk trade-off inherent in owning stocks has, over recent months, deteriorated sufficiently that it is prudent to modestly reduce portfolio exposure to stocks.

We hope you are enjoying the summer. As always, we welcome comments and questions regarding our management of your investments.

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