Many investors fear another bear market is looming with the most recent pullback off the stock market highs in September. A bear market is typically defined as a market decline of 20% or more. There are many factors that could signal the start of a bear market – but bear markets typically happen in and around recessions, rather than in the middle of economic recoveries, such as the one that we believe we’re in now. We feel current market activity is more indicative of a classic correction within an ongoing bull market, rather than the start of a new bear market. Corrections are different from bear markets in that they start sharply (think triple-digit daily declines in the market), are usually based on sentiment-based fears rather than fundamentals, and are short in duration. Bear markets tend to start more slowly and are usually a result of deteriorating economic fundamentals, which is not the environment we are in right now.

The U.S. Economy

The U.S. economy rebounded nicely in the second quarter after a disappointing first quarter decline, posting 4.6% annualized GDP growth. As we’ve mentioned in prior communications, the decline in the first quarter was largely attributed to the severe winter weather on the East Coast and as a result, did not cause a lot of market volatility. Though the third quarter GDP numbers won’t be available for a few weeks, economic analysts believe the economy will grow at approximately 3% (annualized) over the next few years.[1]

Importantly, all of the leading economic indicators point to a continued recovery. For example, auto sales are well above average at 17.5 million units per year, and pent-up demand in housing will likely drive housing starts above the current 950,000 homes per year. Capital goods orders continue to climb as companies deploy more of the cash that’s been piling up on their balance sheets, and there will likely be no additional austerity measures put in place by the government.

The U.S. Bureau of Labor Statistics’ latest jobs report shows that 248,000 jobs were added during September and the unemployment rate decreased again, to 5.9% – both were better than expected.  We’re now close to the Fed’s target for full employment: 5.4% unemployment. Many Americans don’t realize we are now below the historical unemployment rate of 6.1% and we’ve added 10.3 million jobs in the past 5½ years – more than the 8.8 million jobs that were lost during the recession. The percentage of part-time workers (of the total labor force) has declined from 6% in 2010 to 4.7% today, and average hourly earnings are up 2.5% year-over-year. However, labor force participation has declined from 67% of the population in 2000 to 63% of the population today and will likely not recover for many years. This is attributable to a shift in demographics, as Baby Boomers exit the workforce and the overall population ages.

Job Growth (total non-farm employees)

research.stlouisfed.org/fred2/series/PAYEMS/ (as of 10/03/2014)

As we approach full employment, inflation risks increase. This is a classic result of supply and demand forces at work: as the supply of available and desired labor decreases, workers demand greater compensation. Higher wage growth is one of the factors that leads to increasing prices, which leads to inflation. The Fed will have a difficult balancing act in the coming years of increasing interest rates fast enough to mitigate inflation, but not too fast to detract from economic growth.

The Fed has announced its desire to end the bond-purchasing program known as Quantitative Easing and most economists believe October will be the last month of bond purchases before the program is retired. The Fed has been purchasing Treasuries and mortgage-backed securities at record levels over the last few years, increasing its balance sheet by nearly $4 trillion. As this program ends, we expect interest rates on long-term Treasuries to increase. Surprisingly, rates have actually declined even though the Fed reduced purchases through tapering. The yield on the 10-year Treasury in January was about 3% and is now hovering around 2.3%. Many foreign investors have filled the void created by tapering, increasing their Treasury purchases while the Fed reduced its purchases, which has contributed to downward pressure on rates. We feel this is a short-term response and rates will inevitably increase over the next few years, barring an economic shock.

research.stlouisfed.org/fred2/series/DGS10/ (as of 10/10/2014)

Many investors worry that the expected rise in interest rates will dampen economic growth and cause the federal deficit to balloon. Interest rates and therefore borrowing costs will increase for consumers, but so will availability of loans. Low interest rates have resulted in high lending standards and qualifications driving the average credit score for a mortgage to over 740. As interest rates rise, demand for loans will likely decrease, but not as much as supply is expected to increase, as it becomes more profitable for banks to lend. Many investors feel the government deficit will grow due to higher interest (service) costs for Treasuries. The Congressional Budget Office (CBO) has projected the deficit in 2014 to be $486 billion, or about 15% of federal spending, which represents 2.8% of GDP.[2]   In its forward-looking projections, the CBO built in an interest rate forecast of 4.7% for the 10-year Treasury between 2018 and 2024, up from the current rate of around 2%. Even with higher projected costs to service Treasury bonds over the next 10 years, deficits are not expected to go beyond 4% of GDP.  Investors are also concerned that rising rates will negatively affect the stock market. History suggests that stocks actually tend to do well when the 10-year Treasury rate moves up to 5%, but a move beyond that level is detrimental to stocks. This is because rising rates up to a 5% level over time send a signal that the economy is growing.

Slowing growth in Europe and falling inflation in the Eurozone has forced European Central Bank (ECB) officials to ramp up stimulus measures. Europe has been much slower to react to the economic slowdown relative to the U.S. and as a result they’ve had a slower recovery. Recent ECB stimuli include strengthening forward guidance that they intend to keep interest rates lower longer and offering cheap bank financing and outright asset purchase programs similar to the Quantitative Easing program in the U.S. The direction of the ECB balance sheet will soon reverse from contraction to expansion as it tries to spur economic growth. These measures have driven yields lower; 5-year German bunds are now yielding just .19%. It has also helped drive the value of the Euro down, which long term should stimulate exports.

However, short term we expect more mixed news on strength of the European economy. Longer term, European equities could provide investors with a higher return than US equities, given their valuations.

Equities are fairly valued based on almost all valuation metrics, especially after the correction. In almost every bull market, stocks increase in value beyond this historical average valuation. In fact, in low interest rate environments, stocks tend to have higher valuations because competing asset classes like bonds are not paying high enough returns, so investors turn to equities.

Volatility increased at the end of the third quarter and into the start of the fourth quarter as fears of a global economic slowdown surfaced. The S&P 500 has declined over 8% since its peak on September 18[3]. Investors have become accustomed to lower-than-average volatility over the last two years, where we’ve seen corrections of only 6%. While unsettling, daily price volatility is normal. Even with an average intra-year drop of -14% over the last 34 years, the S&P managed to close higher on 26 of those years – over 75% of the time. We expect this recent flurry of volatility to continue as news of the world economies comes to light in addition to problems in the Middle East and Russia. History and studies of investor behavior suggest that trying to time these movements is an impossible task. Typical investors have averaged a mere 2.1% annualized return on their portfolios over the past 20 years (compared with 7.4% S&P index returns[4] ), largely because of market timing attempts and emotions driving investment decisions. Staying disciplined during volatility with a diversified allocation that helps mitigate downturns has driven returns roughly 3 times the average.

Callan Capital Conclusions

Despite being bullish on stocks relative to bonds, we have much lower expectations for future returns than what we’ve experienced over the last several years. Valuations are back to normal and economic growth going forward will likely continue to be slow and steady. As a result, we expect mid to high single-digit growth out of equity markets over the next 5-year cycle. We continue to have a negative outlook on bonds, particularly for long duration high-quality fixed income. We have a bias toward short duration fixed income to protect against the possibility of higher rates. We believe a diversified portfolio with exposure to equities (both U.S. and international), fixed income, and alternative investments is the best way to take advantage of areas of strength and navigate volatile times. If you are a client and would like further detail on these topics or anything else, please don’t hesitate to call or email us. If you are not a client, but would like more information on Callan’s outlook and wealth management services, please contact us at 858.551.3800.

[1] David Kelly, JPMorgan “Guide to the Markets” 10/6/14 As of 9/30/2014

[3] Return on the S&P 500 as of 10/15/2014

[4] Source: DALBAR’s Quantitative  Analysis of Investor Behavior (2014)

Important Index Descriptions and Disclaimers

PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS

INDEX DESCRIPTIONS:

The following descriptions, while believed to be accurate, are in some cases abbreviated versions of more detailed or comprehensive definitions available from the sponsors or originators of the respective indices. Anyone interested in such further details is free to consult each such sponsor’s or originator’s website.

The past performance of an index is not a guarantee of future results. Each index reflects an unmanaged universe of securities without any deduction for advisory fees or other expenses that would reduce actual returns, as well as the reinvestment of all income and dividends. An actual investment in the securities included in the index would require an investor to incur transaction costs, which would lower the performance results. Indices are not actively managed and investors cannot invest directly in the indices.

S&P 500®: Standard & Poor’s (S&P) 500® Index. The S&P 500® Index is an unmanaged, capitalization weighted index designed to measure the performance of the broad US economy through changes in the aggregate market value of 500 stocks representing all major industries.

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Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without previous notice. All information presented herein is considered to be accurate at the time of writing, but no warranty of accuracy is given and no liability in respect to any error or omission is accepted.  This information should not be relied upon by you in evaluating the merits of investing in any securities or products mentioned herein.  In addition the Investor should make an independent assessment of the legal, regulatory, tax, credit and accounting and determine, together with their own professional advisers, if any of the investments mentioned herein are suitable to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. It should be noted that the value of investments and the income from them may fluctuate in accordance with market conditions and taxation and investors may not get back the full amount invested. Both past performance and yield may not be a reliable guide to future performance.

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