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Q2 2016 Commentary

The stock market seems just fine. 

Of course there are plenty of worries in the financial world, but if your perspective is that of a domestically based equity investor, there is not much to complain about.

While stocks have given investors some headaches over the past year, including two brief 10% crashes and a two day 5% post-Brexit decline, domestic equities have been quite resilient.  On a quarterly basis, the S&P 500 closed at a new all-time high.  If you look at daily prices, we closed the quarter only 1.5% below record highs. 

Any lingering frustration with recent market activity comes from investors who may be a bit too used to above average returns.  Even including the S&P 500’s marginal decline last year, stocks have posted annualized returns of 16.7% since the market low over seven years ago.  That is more than double the historical average rate of return.

Since 1950, the only times that we have seen domestic market runs that long and strong were the bull markets of the 1980s and 1990s.  Historically, speaking, investors should be very happy about where they sit today – atop one of the strongest bull markets in history.

Unfortunately for those who are not yet satisfied, runs this strong have never been sustainable. 

Each time stocks have posted similar gains over a similar stretch they have corrected at least 11% (declining an average of 24%) – regardless of valuation. 

Whether you are elated or exhausted by recent moves, we continue to see this market as both expensive and overextended. 

At this point last quarter, we were largely dispelling the vast array of negative storylines that had been fueling market anxieties.  Having profited from those anxieties and once again taken a more conservative position, one would think that we may be inclined to similarly dispel the more positive narratives.

However, we have no issues with many of the ongoing storylines.  The economy seems to have gotten over a hump, and there are no signs of a recession on the horizon.  Sentiment remains depressed and there is plenty of cash on the sidelines.  Earnings are expected to rise this quarter for the first time since 2014.  Globally, central banks remain extraordinarily accommodative.

These are all positive catalysts, but they do not justify markets trading at their current multiples.

We have covered the details extensively in past commentaries, but it bears repeating: every time that stocks have traded at similar levels, it has paid to walk away from the stock market and park money in Treasuries for a decade or longer.  This dour analysis is actually based on an optimistic expectation that we can return to record earnings levels rather quickly. While analysts believe this is probable within a year, we remain skeptical of such estimates, which are pricing in 25% earnings growth over the next nine months.

If these estimates turn out to disappoint, the probability that equities break from historical precedent becomes even slimmer.

Though slim, there is a chance that markets surprise us.  We are in very historic times and have been surprised by the persistence of phenomenon such as negative interest rates.  Throw in a Fed that is increasingly looking amenable to accommodative policy (even in a growth environment), and there remains a possibility that things are different this time.

Weighing these probabilities, accounts across all strategies are targeting close to 35% investment. Because of our concerns, this is the lowest target investment level since 2007; but because of unprecedented central bank action and other positives, this is more aggressive than we would typically be based on valuations alone.  Should equities break to new highs or simply offer us opportunities to exit individual positions, we could easily see our market exposure drop below 20%.

We continue to employ the strategy that allowed us to capitalize on both of the major declines of the last year. Our positioning provides us the flexibility to take advantage of market pullbacks, whether they resemble the numerous speed bumps of the last several years or something more significant.  The exposure we do have is to the some of the more reasonably priced, higher yielding areas of the market.

Though the second quarter was a bit quieter than the first, the fallout from the Brexit vote proved that there is plenty of anxiety in the market.  We would not be surprised to see stocks move dramatically in either direction out of fear, whether it is the fear of losses or the fear of missing out on gains. 

Despite fundamentals, it would not be unheard of for stocks to rally significantly in the intermediate term. Though such a move would not be a surprise, it is not the most probable scenario, and would only leave equities looking more overextended.

Going forward, we will remain patient – waiting for markets to present opportunities, or, better yet, come to their senses.

This quarter, Drach Advisors will celebrate its tenth anniversary as an independent investment advisory firm.  I am very grateful to all of you who have chosen to grow with us over the years.

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