“Do You Find Me Undesirable?” – Mrs. Robinson[i]

Investors face some undesirable choices.  Undesirable candidates, undesirable interest rates, undesirable policy makers and leaders, undesirable social unrest, undesirable economic growth, and an undesirable stock market.
Unfortunately, there is plenty of time for the presidential campaign to get even more undesirable as there is 6 weeks until election day.  Lots of opportunity for a higher level of lunacy.
Turning to the undesirable economy, since the end of the financial crisis, as most know, it has struggled to achieve a normal growth trajectory.  For the past seven years, GDP has expanded below historical recovery rates.  To be sure, some statistics appear strong.  For example, the unemployment rate has fallen and certain real estate markets have rebounded well beyond last decade’s levels. However, the overall level of economic performance has been disappointing, despite the rhetoric.
Last week we had two much anticipated central bank pow-wows.  The Bank of Japan and the Federal Reserve both conducted meetings that included interest rate decisions.  The Bank of Japan announced more unconventional policies on top of the past 20 years of unconventional monetary policy.  The decision included the goal of keeping the yield on the 10-year Japanese government bond at 0%.  The BOJ would adjust the pace of its current bond purchasing program to achieve this objective.
Earlier this year the Bank of Japan joined the Europeans and introduced negative interest rates. The intent was to fight deflation with the goal of 2% inflation. Many questioned this decision as it was more of the same policies used since the 1990’s.  In other words, if you’ve had an ongoing battle against deflation for over 20 years without progress, maybe it’s time to question the tools that you are using.
This was likely what was on Mr. Market’s mind last week as the reaction was not what the central bankers wanted.  Unexpectedly, the yen strengthened instead of weakened and the yield curve flattened.  A stronger yen will be an economic headwind which could increase deflationary pressures.  Further a flat yield curve hurts banks which restricts loan creation.  Again, not helpful if you want higher inflation.
The big news surrounding the Fed’s decision to leave interest rates unchanged was that there were three dissenting votes (voting for a 25 basis point increase).  This marked the most dissention since December 2014.  In defense of holding rates the same, we’ve had some soft economic numbers recently.  There were weaker than forecast ISM numbers at the beginning of September and last week housing starts and building permits were below expectations.  While Chairwoman Janet Yellen suggested an increase in December, the decision will depend on forthcoming data on such things as inflation, employment, productivity and GDP.
The U.S. markets welcomed the announcement and strongly rallied on Wednesday afternoon and Thursday.  That brought the major indexes back to recent highs with the Nasdaq Composite closing at record levels on Wednesday and Thursday.  So much for a September swoon!
Here is where the major averages’ year-to-date performances stand at the end of last week.
2016YTD
DJIA                        +4.8%
S&P 500                  +5.9%                           
Nasdaq Composite +6.0%
Russell 2000            +10.5%                                
 Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividends
The fixed income markets also surged after the Fed meeting.  Bond prices jumped (lower yields) as the 10-year Treasury note’s yield traded back to 1.61%.  This retraced a move higher for this yield as it had spiked to 1.75% earlier in the month as markets absorbed Janet Yellen’s Jackson Hole speech and anticipated the BOJ and Fed.  More importantly, as yields moved lower last week, it eased worries that these higher rates would be an obstacle for stocks and the economy.
Despite being close to all-time highs, many think the markets are whistling past the graveyard.  The list of “undesirables” above are a part of the blemishes that skeptics point to. Also, stocks valuations are not cheap and earnings estimates are being reduced.  Many believe that stocks are up due to central bank policy reducing the relative attractiveness of bonds.  If global central banks stop buying bonds (or even reduce the pace), some believe that the equity markets will fall.
On the bullish side of the debate, stocks have had plenty of chances to retreat but haven’t.  On the contrary, the S&P 500 recently broke above a 2-year range which is strong sign.  Our “undesirables” are widely known and could be priced in.  Further, there are some high profile strategists that think we are just in the middle of a major bull market.  Part of their view is that earnings growth will begin soon and support higher stock prices.
In the short term, it will be constructive if the S&P 500 remains above the 2,140 – 2,150 level.  Trading below this level won’t mean that the party is over but may signal a correction.  On the other hand, this support level could lead to a move to new highs and a year-end rally.
Whatever direction the market moves, it will do so with less investor participation.  $150 billion has been pulled out of domestic mutual funds and ETFs so far in 2016.  Since the financial crisis, outflows have exceeded inflows in every year except 2013.  Investor sentiment is equally pessimistic as bullish percentages have been at historically low levels for many weeks.
To be sure, investors need to remain flexible.  There are opportunities across the assets classes.  Certain sectors of the bond market offer a good balance of risk and reward.  Of course, there are pockets of opportunity within the stock market.  Keeping some cash to take advantage of future situations is also advisable.
It’s remarkable that the markets have done so well considering these indicators.  We would offer that investors view stocks as more than “undesirable” and bordering on “deplorable”.  It would seem that investing in the U.S. stock market is currently the ultimate contrarian position.  There is a Wall Street saying that the ‘hard’ trade is the best trade.  Buying U.S. stocks might fit this definition.
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