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Halftime Report
Toronto: June 30, 2014
By John Stephenson

For the first time since 1993, world stock, bond and commodity markets are all headed for gains in the first half of the year. Through the end of last week, gold has rallied 9.7%, commodity prices are up 8.1%, Treasury notes are up 6.4%, while developed markets around the globe are up 4.8%. The market has been remarkably resilient in the face of uneven economic growth in the U.S. and political as well as economic unrest in the Ukraine and the Middle East.

World financial markets rallying in unison is rare since most commodities and stocks tend to rise in good times, while bonds, along with gold, tend to benefit from economic weakness. One key driver for markets seems to be the decline in the U.S. 10-year Treasury note, which closed last Friday at 2.531%, down from 3% at the end of 2013. Falling Treasury yields caught many investors off guard earlier this year as they thought that yields would rise amid stronger U.S. growth. The falling yield has driven many investors into bonds, commodities and stocks around the world in a search for higher returns.

Despite a sharp selloff in January, investors are now pouring money back into the emerging markets in a search for higher yields. India has been the beneficiary of investor hope that with the election of Narendra Modi, there might be investor-friendly reforms enacted. Mr. Modi is seen as a pro-business reformist and his election has sparked a rally in Indian stocks, sending them up 19% so far this year.

The strong equity markets have spurred a healthy round of merger and acquisition activity with global M&A volumes rising 35% in 2014 when compared to the same period a year ago. Healthcare has been the clear standout winner in M&A activity, accounting for 18% of the global deal total.

One of the more striking features of the U.S. stock market this year has been the big drop in volatility, leading many to suggest that investors are complacent. Policy makers including Fed chairwoman Janet Yellen and Federal Reserve Bank of New York President William Dudley have warned that high prices and low volatility suggest that investors may be growing too complacent, taking on too much risk for too little reward. This coupled with the outsized gains of the more defensive sectors and the overall perception that stock prices are stretched relative to the corporate earnings has many investors boosting their cash levels.

But despite the heady gains in the markets, I believe that the secular bull market in U.S. equities is alive and well. The fundamentals for U.S. corporates remains exceptionally strong with solid operating efficiencies, good earnings consistency and terrific balance sheet strength, making American companies the global go-to equities.   

More good news for U.S. equities could be on the horizon as Japanese officials have gone beyond quantitative easing in a bid to boost domestic growth. Shinzo Abe’s “third arrow” which was unveiled last week, involves instructing Japanese pension plans to increase their allocations to stocks globally. With target allocations increasing for Japan’s Government Pension Investment Fund (GPIF) from 15% to between 17 and 20%, a 1% increase in equity allocation could drive another $5.8 billion into U.S. stock markets.

I believe that 2014 is a transition year for equities, one where investors will begin to focus more on earnings and other fundamental drivers of stock performance and away from central bank actions. Many investors have pointed to the commitment of the Fed, Bank of Japan and European Central Bank in keeping interest rates low while economies continue to recover from the late-2000s recession as reason for the strong gains this year.  Yet in spite of this view of a stimulus-led rally, the S&P 500 market’s return since January has largely been driven by corporate results as opposed to multiple expansion; a healthy sign.

For my money, I’m focusing more of my bets on the U.S. market for the second half of 2014 and screening for both value and high beta (stocks that are the most sensitive to market movements) given that I think the market will soon be entering a period of relative calm where slow, steady gains are the norm. The sectors that I think will be winners in the months ahead are the Financials, which are now the most hated sector in the market and valuation reflects it, the Industrials and Technology. While the market has ground higher so far this year in fits and starts, I’m still bullish on stocks and think that there’s still plenty of good news out there for equity investors.

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I recently launched my own investment firm, Stephenson & Company Capital Management, which is focused on long/short fundamentally driven equity investing primarily in North America. I’m excited about being able to offer investors a vehicle in which absolute returns, risk management and capital preservation are paramount. Later on this week, you’ll be able to find me on the web at www.stephenson-co.com.  

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