With a continuing environment of low interest rates, benign inflation and strengthening economic growth, global bond and stock markets turned in a quarter of impressive results – except for the priciest categories.

Both U.S. large-cap and foreign equities grew 5+%; emerging markets led the way. Fixed income assets gained 1-2%; longer-term bonds fared best as interest rates fell still further. Interestingly, U.S. small-cap stocks, most highly-priced of all equity classes, lagged these results. After falling nearly 10% from mid-March through mid-May, they rallied to a 2% quarterly return; since then, their decline has continued.

What is somewhat surprising is how most U.S. equities continue to reach new highs while their valuations (price relative to profits and profit growth) approach levels that historically precede market downturns. At present they mirror mid-2007 levels, their pre-Great Recession highs. This isn’t to suggest anything similar is imminent. But it likely means 1) the economy, consumer spending and corporate profits are growing faster than we know; 2) they aren’t, but markets will stay at inflated levels so long as the Fed keeps rates this low; or 3) sooner rather than later, returns will slow and stock prices will adjust/correct on their own.

Also surprising is fixed income performance. Recall that any prediction of falling interest rates in 2014 was squarely in the minority. Yet this is what has happened, sending intermediate and longer-term bonds (which always fare worst as rates rise) to 4+% gains and leaving shorter-term notes with less than half that.

How does this affect your portfolio? In short, it adds a cautionary note to how our view since we don’t pretend to predict or ‘time’ key shifts in market direction. Your fixed income holdings are weighted 80% toward shorter-term assets to provide protection when rates do rise. This has helped the last 18 months, though not so far in 2014. Regarding equities, we continue leaning toward value stocks and under-valued areas like emerging markets. We also periodically rebalance when equity gains increase their share of the ‘pie’. This can protect profits and help reduce future volatility while maintaining growth opportunities.

While liking your portfolio’s position, we want to change your small (<3%) commodities and natural resources allocation. Its role is inflation protection and to grow somewhat independent of equity markets. For now, the first isn’t a concern, and commodities haven’t shown recent success at the second. Instead, commercial real estate securities (REIT funds that own real estate investment trusts) seem better suited as commercial occupancy rates rise and economies strengthen. This means replacing your holdings in this category and buying the low-cost real estate index funds offered by Vanguard and Schwab. Should we detect further shifts in economic conditions warranting other changes, we will surely be in touch with you.

As always, we look forward to your thoughts and questions. We send our best wishes for a pleasant summer and as always thank you for the continuing opportunity to work together.