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Investment Strategy

Tuning Out the Noise: All the News That’s Fit for Profit

By Elliott H. Gue, on Jul. 21, 2015

Over the past month, Greece’s potential exit from the eurozone and the precipitous drop in the Shanghai Stock Exchange Composite Index have dominated the headlines, with reporters eagerly citing these events as the cause of innumerable daily developments in the global economy and markets.

Despite their ubiquity in the financial news, neither event affects out market outlook or the picks in our Wealth Builders Portfolio.

Mediterranean Meltdown

Greece’s gross domestic product of about US$240 billion per annum accounts for less than 1.4 percent of the US$18 trillion EU economy. The market’s primary concern has focused on whether the Greek financial crisis could shake confidence in Italy, Spain and France’s sovereign debt, putting these much larger economies under pressure.

Although the euro and EU economy would survive what the infotainment industry has described as a “Grexit,” a financial crisis afflicting the US$2.1 trillion Italian economy or the US$2.8 trillion French economy could tip the Continent into a serious recession and threaten the union itself.

Fears of such a contagion drove huge spikes in the Italian government’s borrowing costs in 2011 and 2012. At the height of the panic, 10-year bonds issued by the Italian government yielded 552 basis points more than German bonds of similar duration.

(Click graph to enlarge.)Third Article - German and Italian Bond Yields

On July 7, 2015, shortly after Greeks voted down a proposed bailout package—the point at which a Grexit looked like a distinct possibility—the yield spread between Italian and German government bonds widened to less than 165 basis points.

This resilience in the face of a potential Grexit reflects the European Central Bank (ECB) and other EU institutions’ efforts to prevent Greece’s problems from shaking the market’s confidence in other European nations.

Among other initiatives, the ECB began buying euro-area bonds in March 2015 as part of a massive EUR1.1 trillion (US$1.2 trillion) campaign of quantitative easing.

Over the past few days, the yield spread between Italian and German sovereign bonds has narrowed to about 110 basis points, fueled by the Greek government’s acceptance of a draconian austerity plan as a precondition to restarting talks on a new bailout.

Although this drama has inflicted significant damage on the Greek economy, the rest of Europe has remained resilient and Wealth Builders Portfolio holding Deutsche X-Trackers MSCI Germany Hedged Equity (NYSE: DBGR) has rallied in recent trading sessions.

The Big Pullback

Shanghai Composite

The financial media has described the severe drop in the Shanghai Stock Exchange Composite Index as a bear market, adopting the standard US definition of a decline of at least 20 percent.

However, the index had generated a total return of almost 160 percent in the 12 months prior to its June 12 high. And even at the nadir of the most recent pullback, the Shanghai Stock Exchange Composite had still gained about 10 percent since the year started.

Volatile markets that experience huge run-ups are also prone to swift corrections and shakeouts.

For example, the Nasdaq Composite Index generated an annualized return of almost 25 percent and a total return of 800 percent in the 1990s. Amid this meteoric rise, the index endured several 20 percent to 35 percent pullbacks, each of which proved to be an outstanding buying opportunity. Describing these corrections as a bear market hardly seems appropriate.

US Economy Stands Strong

The economic news in the US continues to improve, with the Institute for Supply Management’s Purchasing Managers Index for the manufacturing sector climbing 70 basis points sequentially to 53.5 percent in June.

The Conference Board’s Index of Leading Economic Indicators has ticked up by 0.7 percent sequentially in each of the past two months, rebounding from a 0.2 percent decline in February, a period of seasonal weakness.

(Click graph to enlarge.)LEI

Our outlook calls for the US economy to grow at an annualized rate of about 3 percent in the back half of 2015.

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