Mid-Year Stock Market Forecast: Is Volatility a Blip or Trend?

by George Putnam, III
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Submitted by George Putnam, III of the Turnaround Letter as part of our contributors program.

I don’t put much faith in market forecasts, even my own, but the forecasts that I made at the beginning of the year look pretty good right now. Back in January, I expressed optimism about the stock market for the remainder of 2013 and ongoing wariness over high yield bonds – expanding on those concerns the following month: “The yields on junk bonds are at record low levels–below six percent–and we believe that at those levels you are not being adequately compensated for the risks you are taking. The risks in high yield bonds right now come from a couple of different sources….While it’s not certain that the risks will materialize this year, we feel that the longer the current boom in high yield continues, the greater the risk of negative surprises.”

So far this year, the high yield market has been fairly weak. One of the largest high yield bond ETFs, the SPDR High Yield Bond ETF (symbol JNK) is down about 2.5% in price, and with dividends it is about flat for the year. It is also worth noting that my “year-end bounce” stock picks have done particularly well this year – with eight of the ten investment candidates identified up so far this year, and the entire group up an average of 33% YTD, well outpacing the broader stock market. But that’s enough of patting myself on the back for some good calls at the beginning of the year. Let’s turn to what we can expect for the second half of 2013.

While most of the last six months have been relatively placid and profitable for investors, the past couple of weeks have been quite different. When Fed Chairman Ben Bernanke mentioned in mid-month that the Fed was likely to begin cutting back its bond purchasing program later this year, that spooked both the stock and bond markets. In the week and a half since Bernanke’s speech, the stock market became very volatile, with the Dow Jones Industrial Average moving by more than 100 points nearly every day. The bond market has been hit even harder.

I wouldn’t be surprised to see some of this volatility continuing, making the second half of the year bumpier than the first half, and I don’t think that the bond market is likely to perform well for the rest of the year.

As to the stock market though, I am more optimistic for several reasons. Firstly, the reason the Fed might begin reducing its monetary stimulus is that the U.S. economy is improving, which is likely to be good for stocks. Second, while many people think that stocks automatically fall when interest rates rise, research shows that not always to be the case, particularly when rates move up from very low levels – such as where they are now.

Finally, until interest rates rise a lot, investors have few other options right now besides the stock market. If rates do rise, bonds will get crushed. Until interest rates get to much higher levels, holding cash will not be attractive. Gold is falling. Real estate may be improving, but it is always very illiquid. All of this pushes people back to the stock market. Moreover, many investors who have been avoiding the market since 2008 are now getting back into stocks because they are afraid of getting left further behind.

I don’t expect to see stock market gains in the second half of the year that are as large as we’ve experienced over the first six months. Nonetheless, I believe that the market as a whole could rise further, and I still see plenty of good opportunities in individual stocks.

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