Lummer's Logic: 2nd Quarter, 1999

By Scott Lummer
Chief Investment Officer, mPower

The main trends in the stock market during the 2nd quarter of 1999 were the resurgence of small-company stocks and "value" stocks (companies with low prices relative to their earnings), and suspense about what the Federal Reserve would do about interest rates.

Trend #1 - The Resurgence of "Value" and "Small is Beautiful"
Two long-term historical trends that have been documented during the past few decades re-established themselves in the 2nd quarter (April 1-June 30). The first is that smaller company stocks have typically outperformed larger company stocks. The second is that value-oriented stocks (companies that have relatively low prices compared to their earnings) have typically outperformed growth-oriented stocks (companies that have relatively high prices compared to their earnings). While those trends had not held up over the previous two years, the second quarter showed us that in the capital markets history usually does repeat itself.

In my April commentary, I stated the following:

"Over the past couple of years, you would have been better to solely invest in the big-name U.S. stocks, and not diversify across different sectors such as value, small-cap, and international. But that's the past. Going forward, the sectors that haven't done as well as the U.S. large-cap portion of the market are now undervalued relative to that portion. The reason we recommend broad diversification is not to enhance your returns during good times, but to cushion the downside during bad times. Now, more than ever, is the time to continue to follow our well constructed, diversified, investment advice."

Now let's look at results for the 2nd quarter. The S&P 500, a measure of large company performance, increased in value by 8% for the quarter, which of course is very favorable performance for an investment. However, small company stocks, measured by the Russell 2000, increased in value by 15%. Moreover, the average "value" stock outperformed the average "growth" stock by 7%. These results are reminders that it is not wise to bet against long-term trends, even though these trends might not always hold up over relatively short time periods.

Bond returns were sluggish, as the Lehman Brothers Aggregate Bond Index fell by 1%. International stocks also had modest performance, gaining only 2%, mainly because of falling currency values in Europe. However, some international sectors performed very well -- particularly emerging markets, which rose by 29%.

Trend #2 - Inflation, Interest Rates, and the Federal Reserve
The rises and falls in the U.S. market were mainly driven by concerns about inflation and whether the Fed would raise interest rates.

After the market enjoyed an outstanding April, analysts began expressing concern that the economy might be expanding too rapidly. In early May the first signs of increasing inflation began appearing in economic data. By mid-June, it was a foregone conclusion that the Fed would soon raise interest rates -- the only question was by how much.

The mere 1/4% increase announced on June 30 was a relief to the stock market, and this was reflected in rising stock values.

Looking Ahead
Looking forward to the 3rd quarter, there are many reasons to believe the market will continue to establish record highs. However, I see three main concerns.

The first is whether the interest rate increase will truly reduce the inflationary pressures on the economy. It will be difficult for the economy to continue to grow at a fast pace without triggering increasing consumer price levels. If the Fed senses the potential for an increase in inflation, it may very well increase interest rates again before autumn, which is likely to dampen stock prices.

A second and more serious concern relates to corporate earnings. The relatively high stock valuations in today's market reflect optimism about continued growth in profits. If many companies announce earnings below expectations, we could see a potentially severe decline in stock prices.

The final potential danger is the risk presented byY2K. Although this may turn out to be much ado about nothing, the press will certainly express more hyperbole as the year rolls on. If investors believe the concern about widespread problems to be valid, they may take their money out of stocks as a precaution, and the market may decline.

What this means is that there is a fair degree of risk in the stock market – as is typically the case! You should be aware of this risk. However, if you are not planning to retire for several years or more I still believe it is wise to invest a large proportion of money in stock funds.

If you are planning to retire within the next couple of years, though, I think it would be a good idea to consider investing a substantial amount of your savings in safer bond and money market funds.

Moreover, it is always prudent to obtain broad diversification within the stock market, allowing you to benefit during periods like the past quarter.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

Lummer's Logic: 2nd Quarter, 1999

By Scott Lummer
Chief Investment Officer, mPower

The main trends in the stock market during the 2nd quarter of 1999 were the resurgence of small-company stocks and "value" stocks (companies with low prices relative to their earnings), and suspense about what the Federal Reserve would do about interest rates.

Trend #1 - The Resurgence of "Value" and "Small is Beautiful"
Two long-term historical trends that have been documented during the past few decades re-established themselves in the 2nd quarter (April 1-June 30). The first is that smaller company stocks have typically outperformed larger company stocks. The second is that value-oriented stocks (companies that have relatively low prices compared to their earnings) have typically outperformed growth-oriented stocks (companies that have relatively high prices compared to their earnings). While those trends had not held up over the previous two years, the second quarter showed us that in the capital markets history usually does repeat itself.

In my April commentary, I stated the following:

"Over the past couple of years, you would have been better to solely invest in the big-name U.S. stocks, and not diversify across different sectors such as value, small-cap, and international. But that's the past. Going forward, the sectors that haven't done as well as the U.S. large-cap portion of the market are now undervalued relative to that portion. The reason we recommend broad diversification is not to enhance your returns during good times, but to cushion the downside during bad times. Now, more than ever, is the time to continue to follow our well constructed, diversified, investment advice."

Now let's look at results for the 2nd quarter. The S&P 500, a measure of large company performance, increased in value by 8% for the quarter, which of course is very favorable performance for an investment. However, small company stocks, measured by the Russell 2000, increased in value by 15%. Moreover, the average "value" stock outperformed the average "growth" stock by 7%. These results are reminders that it is not wise to bet against long-term trends, even though these trends might not always hold up over relatively short time periods.

Bond returns were sluggish, as the Lehman Brothers Aggregate Bond Index fell by 1%. International stocks also had modest performance, gaining only 2%, mainly because of falling currency values in Europe. However, some international sectors performed very well -- particularly emerging markets, which rose by 29%.

Trend #2 - Inflation, Interest Rates, and the Federal Reserve
The rises and falls in the U.S. market were mainly driven by concerns about inflation and whether the Fed would raise interest rates.

After the market enjoyed an outstanding April, analysts began expressing concern that the economy might be expanding too rapidly. In early May the first signs of increasing inflation began appearing in economic data. By mid-June, it was a foregone conclusion that the Fed would soon raise interest rates -- the only question was by how much.

The mere 1/4% increase announced on June 30 was a relief to the stock market, and this was reflected in rising stock values.

Looking Ahead
Looking forward to the 3rd quarter, there are many reasons to believe the market will continue to establish record highs. However, I see three main concerns.

The first is whether the interest rate increase will truly reduce the inflationary pressures on the economy. It will be difficult for the economy to continue to grow at a fast pace without triggering increasing consumer price levels. If the Fed senses the potential for an increase in inflation, it may very well increase interest rates again before autumn, which is likely to dampen stock prices.

A second and more serious concern relates to corporate earnings. The relatively high stock valuations in today's market reflect optimism about continued growth in profits. If many companies announce earnings below expectations, we could see a potentially severe decline in stock prices.

The final potential danger is the risk presented byY2K. Although this may turn out to be much ado about nothing, the press will certainly express more hyperbole as the year rolls on. If investors believe the concern about widespread problems to be valid, they may take their money out of stocks as a precaution, and the market may decline.

What this means is that there is a fair degree of risk in the stock market – as is typically the case! You should be aware of this risk. However, if you are not planning to retire for several years or more I still believe it is wise to invest a large proportion of money in stock funds.

If you are planning to retire within the next couple of years, though, I think it would be a good idea to consider investing a substantial amount of your savings in safer bond and money market funds.

Moreover, it is always prudent to obtain broad diversification within the stock market, allowing you to benefit during periods like the past quarter.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.