In recent weeks, global equity markets have continued to trade sideways in a volatile range. In fact, most stock indexes have been “stuck” in this sideways pattern since late last year. During this period, corporate profits have continued to grow and unemployment levels have declined – both positive developments for the economy and stock prices. However, certain sectors of the global economy are suffering and China’s once stellar economic growth is now in question. Perhaps it is these conflicting data points that have caused equity prices to be locked in this ongoing trading range? The important question for today’s investor is whether the next big move in stock prices is up and beyond this narrow range – or down significantly from current levels. As a team we are preparing for both scenarios.

Historically, markets that trade sideways during periods of economic growth – what is happening today – usually break out of the trading range and the bull market resumes. We have witnessed this many times in our 22 years at Main Street and there is logic that supports this case. Though stock prices have remained the same for 3 consecutive quarters, corporate earnings have advanced quite respectably. The combination of these data points has actually reduced the markets price/earnings ratio to 16.5 – a reasonable valuation for stocks and not a level at which a bear market would typically begin. The continued progress on jobs also supports the case for continued economic growth not just in the US, but globally. Surprisingly, recent data from Spain, Germany and Italy point to better economic growth ahead and possibly higher stock prices to follow.

Though stock prices may break out to new highs in the coming months, the rising tide is unlikely to lift all ships. At this point in the market cycle, which we would categorize as the late stage of the bull market, it is common that the market’s performance becomes increasingly narrow and certain sectors fail to participate. The very significant decline in energy and material’s stock prices – sectors we sold for you long before they collapsed – are a great example of how today’s global equity market performance has become selective. Investors should pay close attention to this bifurcated market and invest accordingly. Will these sectors revive before the bull market comes to an end? We doubt it, but we will be watching closely. In the meantime, we will continue to invest in those sectors and companies that are performing well and generating great profit growth.

Looking ahead, there are a number of “speed bumps” we need to pass to get to a global equity market that has better footing: China’s recent currency devaluation – the largest in 20 years – and the upcoming Federal Reserve policy meeting, having previously suggested they may begin to raise interest rates. In regard to China, it appears that they are beginning to use policies from the US “playbook.” Devaluing the currency is a way to revive economic growth, which is needed at this point. This recent news about China could have a “silver lining”: it could be the catalyst that causes the Fed to delay the planned rate increase in September, potentially allowing equity prices to break out of the current trading range to the upside.

Though our research suggests that the recent trading range is simply “the pause that refreshes” the ongoing bull market, we recognize that there are unknowns that may alter our forecast. For that reason, we continue to manage risk through your portfolio’s asset allocation, sector management and the use of carefully placed stop loss orders. This Active Risk Management process has mitigated the risk of catastrophic loss in past bear markets and prepares us for what we cannot predict.

All of us here hope you are enjoying the summer and that you find this update helpful in this seesaw market! If you have any changes in your financial circumstances or would like to discuss your portfolio, please let us know at your earliest convenience.

Sincerely,

Your Team at Main Street Research