weekly market review - CLS Investments

WEEKLY MARKET REVIEW AUGUST 9, 2016

Market Performance

In This Edition • Now that markets are reaching new highs, how do investors keep perspective?

Stock Market

LAST WEEK

QTD

YTD ‘16

+0.47%

+4.46%

+8.24%

Domestic Large-Cap Equity2

+0.49%

+4.19%

+8.19%

Domestic Small-Cap Equity3

+0.96%

+6.98%

+9.35%

-0.68%

+4.23%

+3.17%

Developed International Equity

-1.35%

+3.64%

-0.94%

Emerging Market Equity

+1.43%

+6.53%

+13.37%

LAST WEEK

QTD

YTD ‘16

-0.52%

+0.11%

+5.43%

+0.01%

+0.03%

+0.15%

Total U.S. Market1

• What are our top investment concerns?

International Equity4 5

6

• Keep the boomers working.

Fixed Income U.S. Bonds

7

Cash Equivalent

8

Russell 3000 Index 2S&P 500 Index 3Russell 2000 Index 4MSCI ACWI ex-U.S. Index 5MSCI EAFE Index 6MSCI Emerging Markets Index 7Barclays Capital U.S. Aggregate Bond Index 8Barclays Capital 1-3 Month U.S. Treasury Bill Index 1

Week in Review Last week’s stock market performance got August off to a good start and extended gains from July. The S&P 500 rose 0.5%. Small-cap stocks outperformed, climbing 1.0%. International markets trailed, dropping 0.7%. Bonds rose 0.5%, and commodities fell 0.5%. Overall, last week was a good one for investors. The increase in the S&P 500 pushed that index to a new record high. The U.S. jobs numbers and the Bank of England (BOE) led market headlines this week. U.S. nonfarm payrolls surged 255,000. The data suggest economic strength in the U.S. remains intact. The data also showed wages rising more quickly and raised the probability that the Federal Reserve (Fed) will hike interest rates this year. The BOE communicated a much less rosy outlook for the United Kingdom. The bank cut rates to 0.25% and engaged in a number of other measures to spur economic growth. It acted in anticipation of slow economic growth resulting from the U.K.’s decision to leave the European Union. While some action was anticipated by market participants, the BOE acted more aggressively than expected.

A New Record High! Now What? The S&P 500 and the NASDAQ Composite both hit record highs last week. The strong jobs numbers, mentioned above, increased investor confidence and sent the markets to new highs. Whenever market indexes start hitting new highs for the first time in a while, some investors wonder whether it is time to sell. Selling at a new high feels good because sellers can be confident their investment made money if it tracks the broader market relatively closely. Sellers feel smart. They recollect the common expression of the law of gravity: “What comes up must come down.” But that short-term feeling often wears off quickly when the benefits of staying invested continue to bear fruit. Stocks aren’t governed by gravity and record highs aren’t an accident or some statistical maximum. Instead, they reflect improving business performance and expectations for continued growth. In this case, Apple, Amazon.com, Facebook, and Google’s parent company Alphabet helped power the NASDAQ higher because they provide customers value through a business model that rewards shareholders. As some markets hit new record highs (and others don’t), the

Index

 S&P 500 Total Return (Incl. Dividends)  S&P 500 Price Return (No Dividends)

2000

2002

2004

2006

following points may help investors maintain a better perspective about the stock market: • Record highs mean the value of the stocks in an index has reached a new all-time high. Dividends aren’t included, so in periods where stock market index performance is flat, investors still receive the benefit of dividend payments. The chart above shows the S&P 500 through the end of the tech bubble and the financial crisis. Not only has its price recovered since then, but dividends contributed strongly to overall returns.

2008

2010

•

2012

2014

2016

A record high doesn’t mean stocks are expensive. Keep in

mind,

records

highs

are a normal process of investing. Stocks historically go up more than just the rate of dividends. Over the long term, we expect this to continue. Record highs result when the appreciation reaches a new peak. •

Record highs don’t guarantee outperformance Looking

at

either.

sectors

and

regions where performance has

lagged

can

benefit

investors in many periods.

Why a Good GDP Report Might Keep Us Up at Night “What keeps you up at night?,” is a regular question we get from advisors. For some of us, the most accurate answer is our children. But, because that isn’t really what people want to know, CLS Portfolio Managers recently began to publish our top three investment concerns in Monthly Perspectives.

the economy markets.

and

equity

Profit margins, as seen in the chart below, have been in a strong uptrend until recent quarters. Margins increased in recent years, in part because workers have received a smaller portion of corporate revenue.

One of our biggest concerns is U.S. profit margins peaking, as stated below:

The jobs report last week raised concerns that the current decline in margins is coming from tighter labor markets pushing up wages. Nonfarm payrolls rose by 255,000 last month and wages rose at a faster pace than they have in the last seven years. Job growth was broadly positive (see chart). Only the mining and logging industry, which includes drilling for energy, reported employment declines. Over the last year, wages rose 2.6%, which is faster than the rate of inflation.

Profit margins (profits less costs) tend to be a highly mean-reverting data series (moves back to average) due to corporate competition. In the U.S., profits have climbed to record levels over the last several years (peaking profits and bottoming costs) but have recently shown signs of weakness. A pattern of downward reversion could spell persistent pressure on corporate profits, weakening

Strong productivity gains offer the possibility for corporations

and workers to both win. But productivity gains have been slow (see the following section. Faster economic growth also puts pressure on interest rates. The current odds of a Fed rate hike this year remain around 50%. If the improved job growth pushes total economic activity higher, then the Fed becomes more likely to raise rates. Keep in mind that low interest rates reduce the costs of corporations borrowing. Increasing rates mean that new bond issues will require higher rates than some current issues. Who wins from faster growth? European markets are one possibility. European unemployment remains stubbornly high and companies have ample room to increase hiring without igniting any inflation pressure.

Employment change by industry, July 2016, seasonally adjusted, 1-month net change S&P 500 Index Sales, Earnings, and Profit Margin

Sector

Monthly Data 3-31-1973 to 7-31-2016

Mining and Logging

—Income Before Extraorginary Items Margin (7-31-2016 = 7.7%)

Construction

9.0

9.0

Manufacturing

8.5

8.5

Wholesale Trade

8.0

8.0

7.5

7.5

7.0

7.0

6.5

6.5

6.0

6.0

5.5

5.5

5.0

5.0

4.5

4.5

4.0

4.0

3.5

3.5

3.0

3.0

2.5

2.5

2.0

2.0

1.5

1.5

Retail Trade Transportation and Warehousing Utilities Information Financial Activities Professional and Business Services Education and Health Services Leisure and Hospitality Other Services Government -20

-10

0

10

20 30 40 Thousands

50

60

70

80 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016

Boomers Continuing to Work: The Most Important Structural Reform A couple weeks ago, a strategist from JP Morgan visited CLS to share her views on the markets. One subject we discussed was whether governments will enact structural reforms necessary to improve economic growth. Our groups shared a laugh on the subject because “structural reforms” doesn’t have a very specific definition. Whenever it is used on CNBC, it generally means steps to improve growth that aren’t monetary or fiscal policy. It’s never a good sign when something is defined by what it isn’t. A better definition might be reforms to improve economic productivity. In Japan, President Shinzō Abe has successfully implemented some structural reforms. For example, he has taken steps to increase female participation in the labor force and to make corporations more shareholder-friendly. But the pace has been slow and erratic. Other regions also lag behind in necessary reforms. Europe

hasn’t reformed its labor laws to make hiring workers less risky. The United States still taxes income earned overseas a second time and maintains a very high corporate tax rate. The Trans Pacific Partnership (TPP), which implements a number of structural reforms in multiple countries, looks unlikely to pass. Political opposition makes passing reforms difficult. In Asia and Europe, “jobs for life” has undercut profitability, but reforms put individuals at greater risk of losing their jobs in the short term. This isn’t the political year in the U.S. to advocate for cutting taxes or signing a new trade deal. Rather than approach the issue from a political standpoint, it may make more sense to focus on the economics. New research from the Rand Corporation suggests keeping experienced workers in the labor force is the key to improved economics. A paper authored by Nicole Maestas, Kathleen Mullen, and

David Powell found that a 10% increase in the fraction of the population 60 or older decreases GDP growth by 5.5%. There are a couple common reasons cited for why this happens. The first reason is the labor force is smaller because workers don’t produce as much when retired. Statistics suggest this accounts for about one-third of the 5.5% decline. An oft-cited second reason is older workers are less productive. The research in the article suggests blaming older workers isn’t very accurate. Instead, productivity at companies falls for all age groups when older workers leave the workforce. The authors draw the following conclusion: “We interpret this as indicating that older and younger workers are complements in production, and so the productivity of the older workforce affects the productivity of the younger

Scott Kubie, CFA Chief Investment Strategist Scott Kubie joined CLS as a Portfolio Manager in November 1995. In March of 2002, he was given additional responsibilities as the Director of Research. In response to rapid asset growth at CLS, Mr. Kubie moved to the role of Chief Strategist in June 2005. Mr. Kubie holds a Bachelor of Arts degree in Business and Economics from Trinity University in San Antonio, Texas, and a Master of Business Administration from the University of Nebraska at Omaha (UNO). He holds Series 6 and Series 65 securities registrations as well as the Chartered Financial Analyst (CFA) designation.

Boomers Continuing to Work: The Most Important Structural Reform workers. This pattern could arise from a loss of positive spillovers from older to younger workers if productive older workers are more likely to exit the labor force.” Put in simpler terms, older workers help younger workers solve problems more quickly and

become more productive faster. When an experienced worker leaves the firm, they take their wisdom with them. That wisdom is a powerful economic tool. So what should countries do to improve their economies? Tax incentives and other rules should be adjusted to make it easier for workers to continue to

work. Greg Ip, of the Wall Street Journal, suggests increasing the benefits for delaying Social Security and reducing tax penalties on earnings if they are already collecting Social Security. That would be a positive structural reform.

The Russell 3000 Index is an unmanaged index considered representative of the U.S. stock market. The index is composed of the 3,000 largest U.S. stocks. The S&P 500 Index is an unmanaged composite of 500-large capitalization companies. This index is widely used by professional investors as a performance benchmark for large-cap stocks. The Russell 2000 Index is an index comprised of the 2,000 smallest companies on the Russell 3000. It serves as a benchmark for small-cap stocks in the U.S. The MSCI All-Countries World Index, excluding U.S. (MSCI ACWI ex US) is an index considered representative of stock markets of developed and emerging markets, excluding those of the U.S. The MSCI EAFE Index is a composite index which tracks performance of international equity securities in 21 developed countries in Europe, Australia, Asia, and the Far East. The MSCI Emerging Markets (or EM) Index is a composite index which tracks performance of large and mid-cap firms across 21 countries classified as emerging market countries. The Barclay’s Capital U.S. Aggregate Bond Index measures the performance of the total United States investment-grade bond market. The Barclay’s Capital 1-3 Month U.S. Treasury Bill Index includes all publicly issued zero-coupon U.S. Treasury Bills that have a remaining maturity of less than 3 months and more than 1 month, are rated investment grade, and have $250 million or more of outstanding face value. An index is an unmanaged group of stocks considered to be representative of different segments of the stock market in general. You cannot invest directly in an index. The views expressed herein are exclusively those of CLS Investments, LLC (CLS), and are not meant as investment advice and are subject to change. CLS is not affiliated with any companies listed above. No part of this report may be reproduced in any manner without the express written permission of CLS. Information contained herein is derived from sources we believe to be reliable, however, we do not represent that this information is complete or accurate and it should not be relied upon as such. All opinions expressed herein are subject to change without notice. This material does not constitute any representation as to the suitability or appropriateness of any security, financial product or instrument. CLS is not making any comment as to the suitability of any funds mentioned, or any investment product for use in any portfolio. There is no guarantee that investment in any program or strategy discussed herein will be profitable or will not incur loss. This information is prepared for general information only. It does not have regard to the specific investment objectives, financial situation, and the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any security or investment strategy discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investors should note that security values may fluctuate and that each security’s price or value may rise or fall. Accordingly, investors may receive back less than originally invested. Past performance is not a guide to future performance. Individual client accounts may vary. Investing in any security involves certain non-diversifiable risks including, but not limited to, market risk, interest-rate risk, inflation risk, and event risk. These risks are in addition to any specific, or diversifiable, risks associated with particular investment styles or strategies. The graphs and charts contained in this work are for informational purposes only. No graph or chart should be regarded as a guide to investing.

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