You would have to have been an active investor in the 70’s and 80’s to recall one of the great investors of our lifetime — Martin Zweig. Zweig “called” the 1987 stock market crash just days before it came to fruition. He was known for his flexible approach to investing (an approach our team embraces) and his famous quotes such as “don’t fight the (ticker) tape” and “don’t fight the Fed.” Recent Federal Reserve commentary, along with significant stock, bond and interest rate fluctuations, bring to mind Marty’s rigorous analysis of history, markets and the affect of Federal Reserve commentary versus policy. Though we lost Marty in February of this year at the young age of 70, we are pretty sure what he would be expressing and doing in today’s markets.

Marty Zweig was known for his research, which validated that financial markets, in the intermediate and long term, are primarily driven by Federal Reserve policy — and not necessarily commentary. When the Federal Reserve is accommodative by keeping rates low, as has been the case since 2009, stock prices will have the wind at their backs. In fact, only when the Federal Reserve has actually raised interest rates not once, but twice, have stock prices had a history of falling into bear markets — a decline of more than 20%. It is with these thoughts in mind that we caution against using recent stock market weakness as a sign of the end of the bull market in stocks. Marty Zweig would find comfort in the fact that recent Fed commentary is just that and is only a forecast of what may possibly be. A forecast that if Bill Gross of PIMCO is correct, could be dead wrong. As far as Mr. Gross is concerned (and he is also an expert of Fed policy) the mere idea of the Fed possibly raising rates in 2014 seems very unlikely. Therefore, stock prices may continue to ride the wave of easy Fed policy for some time to come. However, this may not be true for the bull market in bonds that very well may be coming to an end.

Since 2008, the yield on the 10 year US treasury has fallen from 5.6% annually to under 1.5% just a few weeks ago. Most of this historic decline was a result of the Federal Reserve actively lowering interest rates — such as the Fed Fund rate — or through the purchase of bonds, which also lowers overall interest rates. All of this activity was conducted with the idea that lower rates would save the US, if not the global economy, from falling into a depression and to stimulate economic growth. The historic decline in rates did prevent a global depression but failed to stimulate even average growth. Hence, the lower than normal US and global growth in recent years. However, declining interest rates caused bond prices to rise significantly over the past 5 years — to a point, we believe, that is unlikely to continue and will eventually reverse. At yields below 2% or even 3%, the bond market adds little value for investors given that inflation eats up a big chunk of this return. Moreover, the mere idea that rates may rise — pushing bond prices down — makes bonds even less appealing. One could argue that a further significant decline in rates would make bonds appealing. However, how much room is there between current yields and zero?

Given these dynamics and Federal Reserve commentary, our research suggests that investors have begun and will continue to exit the bond market. The 65 billion dollar question is “where will that money go?” Our research suggests that it will go into global stock markets. Global stock markets by just about every measure are undervalued relative to history and, given the low interest on money markets, are the obvious alternative to the bond market. Additionally, the continuation of economic growth, though subpar, supports the case for stocks as corporate profits continue to grow. As the historic level of money in bond the bond market flows from bonds back to stocks, the positive effect on stock prices cannot be — and should not be — underestimated.

Marty Zweig (may he rest peacefully) would suggest that this period of rising stock prices will eventually come to an end after the Fed has actually raised rates twice, long bond yields are less than that of short bonds, or P/E ratios are excessive. None of these are even close to being a reality in today’s global stock market. However, investors should be aware that unexpected events can occur that can topple even the most optimistic outlook. Therefore, we will continue to manage your risk through your portfolio’s asset allocation, sector management and the use of carefully placed stop loss orders. All of these tools are intended to mitigate the risk of catastrophic loss.

We hope this update finds you well. If you have any questions or have experienced a significant change in your financial circumstances, please let us know.

Sincerely,

Your Team at Main Street Research