Second Quarter 2014 Commentaries

Dear Clients,

Major stock market indices started the quarter trading rather nervously. S&P 500 was down during the first week of trading, and then continued to the second week. But that did not last long. By the third week, stocks had regained their swagger. Quietly inching up almost daily, S&P 500 finished the quarter with an impressive gain of 5.23%.

2014 is the sixth year of the current bull market. Having appreciated nearly 200% since March of 2009 and more than 30% alone in 2013, there had been widespread expectation of a correction. Alas, waiting for the correction is much like waiting for Godot. It has yet to arrive, but surely it will tomorrow.

However, the greatest surprise so far in 2014 is not that stocks are up over 7%. It is the fact that bonds have rallied, yields have fallen and spread have tightened. With the rally in bonds showing no signs of reversing, it is investors who are capitulating. As the extreme low rate environment persists, investors are becoming more accustomed to the idea of 1.5% 10-year Treasury yield. The resulting search for better return, in my opinion, has been the driver behind this equity market rally.

Bear markets are characterized by tight liquidity, deteriorating fundamentals and investor euphoria. Judging by the rally in bonds, liquidity is still supportive. As the economy continues its slow but steady growth, fundamentals are at worst neutral and investors for the most part are still under-allocated to equities. It is for these reasons that we remain invested in the equity market today despite somewhat elevated valuation.

Even though signs of bear market are not present currently, it does not mean it will not materialize indefinitely. The recently release annual report by International Bank for Settlement contained a surprising warning, “Financial markets are euphoric, in the grip of an aggressive search for yield . . . and yet investment in the real economy remains weak while the macroeconomic and geopolitical outlook is still highly uncertain.” This opinion by the BIS is of course not new, but the fact that such an usually staid organization felt compelled to issue this statement reflects the unease with which investors have received this 5 year bull market.

I do agree that a liquidity driven bull market is not a healthy one. However as the experience of Japan demonstrates, rates can stay low for many years and as a result, equity valuation can remain lofty for years as well. It is worth repeating that I think the greatest enemy to this bull market is inflation. As long as inflation stay contained, the spoon that succors this market will continue to supply the necessary nutrients.

Dong Hao Zhang
President & Chief Investment Officer Evla Hills Investment Management