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The stock and bond markets continued their winning ways this year as the U.S. equity markets set multiple record highs during the second quarter.  The bond market rose during the quarter, pushing yields lower.  We are seeing mixed, although mostly favorable economic data, which is providing the fuel for stocks to rise.

Falling interest rates are usually a sign the bond market is forecasting a slowing economy, while rising stock prices are a sign the equity markets are forecasting a growing economy.  It is interesting to look at the factors that are giving us these seemingly opposite outlooks.  Stocks, in the short run, are very volatile as investors discount the likelihood of various things happening.  Our economy has been growing since 2009 and optimism has been growing for eight years.  It is worth noting, however, that 40% of the gain this year in the S&P 500 is due to just four companies.  This latest uptick does not have broad market breadth, which is usually a warning sign that the rally is not sustainable.  As we have stated in our past few letters to you, we are also seeing signs that are typical of a late bull market run.  Bond yields have been dropping as we are seeing little evidence that the tight labor markets are leading to rising wages, which suggests that inflation remains in check.

People sometimes misinterpret what we mean when we say the stock market is expensive. The fact that the Dow Jones Industrial Average is over 20,000 does not mean the market is overpriced. The market is only over or under priced relative to the earnings that are produced by the companies that make up the index. After the bear market in 2008, the market doubled in price but earnings also doubled, so the index did not get any more expensive. One of the metrics we use to determine market valuation and our overall asset allocation is the CAPE ratio, or the cyclically adjusted price earnings ratio. We could fill many pages with our methodology on building portfolios based upon different valuation levels, but suffice it to say that as stocks get more expensive we become more conservative, and as stocks become cheaper we become more aggressive. It is worth noting that the CAPE ratio is currently near 30, and since 1880, there have only been two times it has been higher than this: 1929 and 1999. In both of these time periods, these market valuations were unsustainable.

We are not predicting a market crash or even a deep sell off. We do, however, think that the upside potential in stocks is limited at current levels. For the longer term, stocks should still be held as markets can stay overvalued for a long time and are impossible to predict in the short term. In the near term, we have become somewhat more conservative in our allocations.