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2nd Quarter 2016

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The Standard & Poor's 500 index of large U.S. companies posted a 2.5% gain in the second quarter despite a frightening Brexit 5.3% sell-off and snapback at quarter-end that whipsawed hot-money investors.

Stocks drifted higher for most of the second quarter. On Friday, June 24, the first day of U.S. stock trading after Britain's vote to exit the European Union, stock prices plunged 3.8%. The following Monday, June 27, it dropped another 1.5%. Then, just as quickly, sentiment changed and the market recovered the last week of the quarter.


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The U.S. stock market's strength in the second quarter of 2016 reflected a stream of improved data on the economy, including these seven positive signals: 1.strengthening personal income and spending growth
2.strong retail sales
3.a rising index of leading economic indicators (LEI)
4.a new low in unemployment
5.record-high job openings
6.the Fed's reiteration of its intent to maintain its stimulative monetary policy
7.the projected recovery in S&P 500 earnings following a yearlong earnings recession

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In the quarter ended June 30, 2016, large-cap growth-style investments trailed all other styles by a considerable margin.

Looking at just three months of data often doesn't reveal important intelligence, but it is part of the big-picture perspective in managing a portfolio.


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The energy sector came roaring back in the second quarter, as crude oil prices recovered from a historic bottom of $30 per barrel in February.

Telecom services and utilities -- the two most defensive sectors and sensitive to interest-rate fluctuation -- outperformed the eight other industry sectors.


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While we're on the subject of the Standard & Poor's 10 industry segments, it's fun to check periodically on how Wall Street's industry forecasts are performing.

Barron's, a venerable weekly financial magazine owned by Rupert Murdoch's American publishing empire, which also owns The Wall Street Journal, annually interviews 10 "top" strategists from Wall Street's largest firms, and performance of their industry forecasts is tracked for us by independent economist Fritz Meyer.


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Here are their sector picks and pans for 2016 that were listed in the Barron's cover story of December 14, 2015.

It's easy to see from this chart that Wall Street's sector forecasts -- shown in color -- for the first half of the year were not working out very well.

Energy, telecom, and utilities -- the top sectors in the first half of 2016 -- were not among those picked to outperform last December by Wall Street's strategists. Meanwhile, seven of the 10 Wall Street strategists predicted tech would outperform for 2016, making it the second-most popular pick for 2016. Tech, however, was the worst-performing sector in the second quarter.

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This data is unusual to come by.

Fritz Meyer was the senior strategist at one of the world's largest investment companies for many years before going independent in 2009. He's been tracking the performance of the Wall Street's sector picks in Barron's annually for over a decade, and he says Wall Street's picks have performed poorly year after year.

Like us, Meyer is independent of Wall Street and its culture of sales. That's one of the reasons why we so often quote his research.

Meyer sells no products, just independent analysis.


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This chart shows a compilation of all sector picks minus pans versus actual end-of-year sector returns for the eight years from 2007 to 2015 – every year since Barron's began taking this survey of strategists' picks and pans.

If the strategists surveyed, collectively, were able to systematically give valuable sector-picking advice, then these data points would lie near the 45-degree angle in red.

However, the scattering of data points looks random.


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Not to be unkind, the simple truth is that the picks by Wall Street's so-called top strategists in Barron's are about as reliable a methodology as monkeys throwing darts.


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In what has become a common quarterly pattern, U.S. stock indexes outperformed their foreign counterparts.

Eurozone stocks have suffered a most cruel fate in recent months.

The No. 1 performer in calendar-year 2015, Eurozone bourses fell from first to last place in the first quarter of 2016, and again in the second quarter.


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Crude oil, MLPs and commodities all reversed course and soared in the quarter ended June 30, 2016. Oil stock performance has been a virtual "poster boy" for broadly diversifying the core of a portfolio in low-cost vehicles.

Gold gained another 7% in the second quarter. That came on top of a huge first-quarter gain of 17% -- following its multiyear decline through 2015.

Notably, every asset class gained in the second quarter. The S&P 500 gained the least among the 12 asset classes listed, which makes complete sense because of the nature of indexed investing.

Overall, this chart is a classic picture, showing how the most broadly diversified index, the S&P 500, always underperforms more concentrated constituent sectors in the short run. It's an argument for patience and avoiding seductive short-run outperformance of the hottest sectors.


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Let's review factors impacting the performance of America's blue-chip companies in this 12-month period ended June 30th.

The S&P 500 index gained just 4% over the 12 months ended June 30, 2016. A collapse in profits hit energy and mining companies hard, and hurt earnings of the S&P 500.

A four percent return is less than half the average annual return of about 10% on U.S. large-companies' equities since 1926.


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2016 started poorly. Within two weeks, the Standard & Poor's 500 stock index had fallen almost 10% from a December 29th high, and the financial press was filled with dire predictions.

While it may seem like a long time ago, these were the headlines excerpted in our update in January 2016. Pessimism abounded to start the year and it fueled Wall Street's worst start ever to a new year in Wall Street's history.

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Bad news hit U.S. markets at the opening on August 11, 2015, after China slightly devalued its currency, the yuan.

Combined with fears that the low in commodities prices might trigger a global economic slowdown, the devaluation set off an unexpected chain of events, cited as contributing to an infamous "flash crash" of August 24, when Wall Street opened, as usual, at 9 a.m. and in seconds plunged 11%.


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Stocks rebounded from the August flash crash, and before nervously stumbling ahead to end the year not far from its all-time high.


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Then, in the first quarter of 2016, almost the same confluence of bad events that triggered a selloff in August, occurred once again. China announced a weak Purchasing Managers Index figure; fears of a global slowdown spread after crude oil prices hit a bottom; and stocks plunged 12% in yet another correction. It was widely reported to have been Wall Street's worst start to a new year ever.

The first three months of 2016 were a seesaw ride for stock investors.


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While you could almost see the bears moving in to end the bull run on Wall Street, something about this picture did not make sense.

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On February 12, 2016, when stocks were trading down in lock step with oil prices, we reported here that the "sudden correlation of stocks and oil prices is remarkable for revealing just how irrational and emotional the stock market can be."

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Throughout the past 12 months, despite the market volatility, in these weekly email updates, we have continued to focus on economic fundamentals.

This slide from our email update on May 20, 2016, reported on the slew of positive economic news, which, already at that time, had been coming in for months.

Housing starts, the consumer price index, and the index of leading economic indicators -- were all on an even growth path.


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By the end of the first quarter of 2016, however, as global economic data firmed up, U.S. economic data led the way.


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New-job formation was soaring, the rate of unemployment declined to lows not seen in over a decade, and the forward-looking index of leading economic indicators (LEIs) was forecasting growth just ahead.


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Our 12-month tour ends with Britain's stunning vote to exit the European Union. In the final week of the second quarter of 2016, history was made when Great Britain surprised the world by exiting the four-decade old effort to create a common market with Europe.

Within hours of the 3.8% sustained on June 24, we reported the June 24 "Brexit selloff" was a political crisis and not an economic one.


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Great Britain and the European Union account for 2% of U.S. gross domestic product, according to Shehriyar Antia, a former senior analyst at the New York Federal Reserve Bank.

If all trade with Great Britain and the E.U. were to end, the impact on the U.S. economy would be marginal -- and even that is not happening!


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Britain and Europe will go on trading as they have been doing.

Immigration policy and politics are all that's changed.

Brexit may cause a recession in Great Britain, but that does not change the forecast for the American economy, which is uniquely insular compared to other nations.

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For the 12-month period ended June 30, 2016, the large-cap growth and value stocks substantially outpaced mid-cap and small-cap companies.


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Utilities, telecom, and consumer staples led all sectors in the 12 months ended June 30, 2016.

Utilities, telecom, and consumer staples are the most defensive sectors, and they outperformed.

Meanwhile, over the 12-month period, the broad market went sideways.

The one-year sector performance figures are a bad surprise for most Wall Street strategists, as these three sectors were "panned" by the strategists in 2015, and again in 2016.

This is based on research by independent economist Fritz Meyer, whose research we often share with our network. Meyer has tracked Wall Street's top strategists every year since 2005 in an annual Barron's cover story in which the venerable financial weekly asks Wall Street's "top" strategists to forecast which sectors will wax rich and which shall suffer a loss.

Over the years, Meyer, a strategist at one of the world's largest investment companies for a decade before going independent in 2009, says Wall Street experts are consistently bad at predicting performance of a sector one-year hence.


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For the 12 months ended June 30, 2016, U.S. stocks outperformed the rest of world's major regional stock indexes.

Among the U.S. indices, the large-caps making up the S&P 500 outperformed mid- and small-caps.

China's fledgling and government-rigged stock market lagged badly. Emerging markets and Eurozone indices continued their long-held pattern of volatility.


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Asset classes are important components in diversification and this chart is a picture of why that is so.

The dispersion of returns in this rainbow of investments is why savvy investors don't try to pick the next hot sector.

For the 12 months ended June 30, 2016, REITs, both U.S. and global, tallied the best returns.

In a reversal of a five-year slide, gold rose by 12% over the past year.

At the bottom of the one-year ranking, crude oil and related MLPs posted major losses, as did commodities.


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From the start of 2015 through mid-July 2016, the stock market has been level -- although the period was punctuated by two corrections in the low double-digits.

America's largest publicly held companies -- the S&P 500 -- had tripled in value from a March 2009 bear-market bottom to their highs, and the seven-year economic expansion, one of the longest in modern U.S. history, is still intact.

In past 11 months, the stock market experienced two 10% corrections. Those setbacks had been long-anticipated following four years of relatively low downside volatility in share prices.

Over the last five years, including dividends, the S&P 500 total return index has gained 77%, compared with a gain of 59% in the commonly quoted S&P 500 price index. The 18% difference is attributable to reinvested dividends.

Since 1900, only three of 23 bull markets have lasted six years or longer. The likelihood of a bear market -- a correction of at least 20% -- increases as the bull market grows older.

However, fundamental economic conditions that have accompanied bear markets in the past were on the horizon as of mid-July 2016.

None of the signs of an economy about to slow -- restrictive Fed policy, stock market overvaluation, or irrational exuberance -- are threatening to end the expansion. In fact, the economy was gathering steam as the third quarter approached.


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For the five years ended June 30, 2016, what particularly stands out is how large-cap growth so substantially beat the five other styles of U.S. stock investments. The 84% total return on large-growth company share prices over the five-year period was much higher than the other styles of U.S. stocks.

The 10 most influential stocks on the performance of the S&P 500, as of June 30, were: Apple, Microsoft, Amazon, Facebook, Alphabet, Johnson & Johnson, General Electric, Home Depot and Walt Disney. Apple, Amazon, Facebook and Alphabet (Google) are pre-eminent leaders of the new information technology economy.


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Health care, consumer discretionary, and consumer staples -- growth areas -- all were the leaders in the five years ended June 30.

Conversely, the lagging sectors were those classified as value-style investments -- energy, materials, financials, and telecom services.

The energy and material sectors were slammed by the collapse in crude oil prices and the price of most other commodities.


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In what seems at times to be a bleak period in history, when terrorist atrocities are reported almost daily, and America's enemies are absolutely frightening, the U.S. continues to be the world's capitol of capital.

For the five years ended June 30, 2016, the stock U.S. indexes -- small-, mid-, and large-cap -- outperformed the rest of the world's major indexes.

The U.S. economy has been leading the world economy since the global financial crisis seven years ago.


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REITs, both U.S. and global, were the top performers, for the five-year period ended June 30, 2016, along with U.S. large-cap stocks.

Among this broad array of asset classes, crude oil took last place. Commodities and gold have been losers over the five years.


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It's an election year and, from both sides of the Congressional aisle, politicians are saying Americans have not had a pay raise in many years. At best, they're uninformed.

Real disposable personal income and spending have been growing at a healthy clip. To be precise, between May 2015 and May 2016, the growth rate in real DPI was 3.2%. What does that mean?

The 3.2% growth rate in DPI is better than the 2.8% rate from July 2002 to July 2007, an expansion built on too much debt.


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Consumer spending accounts for 69% of U.S. economic activity. It is the key driver of GDP growth.

What drives consumer spending?

Real disposable personal income.

On this score, the economy is looking fairly strong.

Real disposable personal income growth is expected to continue to drive a 2.4% rate of real GDP growth over the final three quarters of 2016.

In early June, The Wall Street Journal surveyed approximately 70 economists on their quarterly GDP growth forecasts through 2016. The resulting consensus forecast is illustrated in this chart.

Strength in the rate of GDP growth is expected for the quarters immediately ahead.

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Inflation remains well below the Fed's 2% target rate. Coupled with Brexit jitters, these two fundamentals make a Fed rate hike less likely in 2016.

Headline inflation (PCE) -- the inflation metric reported most often in the financial press -- has plunged, and partially recovered from the historic lows in gasoline, diesel, and fuel oil prices in February 2016.

The less-quoted but more influential inflation metric, Core PCE, excludes food and energy expenses in its monthly calculation. At 1.5%, it's higher than the headline inflation rate. However, the core inflation rate, which is a metric used by Fed policymakers in setting interest rates, is also below its 2% target rate.


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Following a flat 2016, earnings are forecast to surge 14% in 2017 over 2016. The stock market already has priced what amounts to an earnings recession for 2016. The forward-looking earnings projections are a significant improvement over 2016.

Of all the charts we analyze every month, this one best illustrates how the stock market works. The black line represents stock prices. It tracks with the red line, which represents earnings on America's blue chips since the last quarter of 1988.

The latest consensus forecast of economists for S&P 500 earnings in 2017 is for operating earnings to average $136 per share of the S&P 500.

Despite the terrific run of stocks for over five years, valuations compared to underlying earnings are not stretched, particularly when compared to the second half of the decade of the 1990s when irrational exuberance really took over.

The gap that opened between earnings and stock prices in 1998 and 1999 was much wider than any other period on this chart, dating back to the end of 1988. While a gap between prices and earnings has opened in the last couple of quarters, it remained small as of June 30, 2016.


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No one can predict what will happen.

Terrorism, natural disaster, political strife, and so-called black swan events that no one ever expects, can become reality and change financial markets dramatically at any given moment.

That's always been true, although it seems harder than ever to believe.

Over long periods of time, however, we know humans make progress. We learn and make things better.


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Unless some unexpected event steers earnings or prices off course -- if history is a guide -- the black line representing stock returns, always in the past, was pulled toward the red squares. That's not a forecast. Past performance is not a guarantee of future results. However, it is a possible outcome in the future -- assuming the world works according to a plan, which we all know rarely happens.

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Historically, when inflation is low, investors are willing to pay seventeen dollars and ninety cents a share for a dollar of earnings on the Standard and Poor's 500 index.

And the latest P/E ratio, as of June 30th, was exactly 17.9.

Stocks are not overpriced, but they also are not underpriced.

The valuation placed on stocks is exactly the same as the average P/E ratio on the S&P 500 over the past 55 years.

Stocks are fairly priced.

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3rd Quarter 2018
2nd Quarter 2018
1st Quarter 2018
4th Quarter 2017
3rd Quarter 2017

This article was written by a professional financial journalist for Legend Financial Advisors, Inc.® and is not intended as legal or investment advice.
@2018 Advisor Products Inc. All Rights Reserved.


©2018 Legend Financial Advisors, Inc.®. All rights reserved.