The third quarter, the worst one for Wall Street in four years, has mercifully come to an end. It began with the first International Monetary Fund default by a developed country (Greece) and finished with Hurricane Joaquin possibly headed toward the east coast. In between, China’s stock market tumbled, the Federal Reserve tried to interpret conflicting signals, and trade growth slowed globally. The U.S. stock market finally succumbed to the selling pressure that had been affecting financial markets across the globe and the major market indices did not fare well through the dog days of summer. The S&P 500 Index lost 6.44%, the Dow Industrials Average Index declined by 6.98%, and the NASDAQ Composite Index and Russell 2000 Index shed 7.09% and 11.92% respectively. Moreover, every equity index finished the first nine months of 2015 in negative territory. All the sectors of our domestic economy except utilities declined during the third quarter and only one of them – consumer discretionary – remained positive for the year. But here is an interesting observation: the market’s pain was overwhelmingly concentrated within a four-session span that ranged from August 20th to August 25th, when China surprised the markets by letting the renminbi exchange rate float more freely. In fact, in just two of those days, Friday, August 21st and Monday, August 24th, the S&P 500 Index lost 7.00%. In other words, aside from those two consecutive days, the market was up by a fraction for the last quarter and the year. What is important to note is while recoveries are often slow and steady, the selloffs are always quick and sharp, and, for the most part, are over at just about the time people are starting to realize the market is going though one.
The Chinese economy’s slowdown and currency devaluations put more pressure on international markets. The MSCI EAFE Index of developed countries lost 10.75%, and the MSCI Emerging Market Index declined 18.53% for the last three months.
The fixed income markets held steady with the Barclays Aggregate Bond Index posting a small gain of 1.24% for the quarter and 1.13% year-to-date. The yield on the 10-year U.S. Treasury Note started the quarter at 2.46%, briefly fell below 2% amid the equity market turbulence in August, and stood at 2.06% on September 30th.
Second-quarter GDP turned out to be much better than originally thought. The second estimate of Q2 growth from the Bureau of Economic Analysis came in at 3.7%, much higher than the initial estimate of 2.3% and topping the 3.1% consensus forecast. Additionally, capital goods orders and industrial output rose in July and August.
Other economic reports were mixed. The auto industry had a strong quarter with auto sales rising to the best level since the beginning of expansion. Consumer spending and personal income rose due to low oil prices. Inflation was up just 0.3% from last August, but core inflation, less food and energy, increased 1.3%. The Institute for Supply Management reported its manufacturing index fell in September to its lowest level since May 2013. Home prices reached an eight-year high but pending home sales were down 1.4% in August. The Commerce Department said that construction spending reached its highest point since 2008 in August, rising 0.7%, but the factory orders were down 1.7% in August recording its biggest dip since last December.
After the last Fed Policy meeting in September, which left the short term interest rates unchanged, the Fed’s Chairwoman Janet Yellen said that a rate hike was still likely to occur in 2015, despite a rate of inflation well below the Fed’s target of 2% and the recent stock market turmoil. However, the most positive economic indicator the Fed has had to hold onto – job growth – has now slowed, casting our doubt on a possibility of any rate increases this year. The government announced that only 142,000 new jobs were added in September, well below the forecast of 200,000, and another 59,000 were shaved off the totals for July and August. By way of comparison, an average of 167,000 jobs were created each month in the third quarter of 2015 as compared to an average 260,000 a month for all of 2014. The separate household survey showed that the jobless rate was unchanged at 5.1%.
The S&P 500 Index registered its first correction since 2011, declining more than 10% from its high in May. However, as long-term investors, we prefer to focus on the economic cycle, as the drivers that determine when the expansion ends and the recession begins matter more to us than near-term market fluctuations. The key question for investors today is whether the pullback represents a momentary pause in the current economic cycle, as in 2011, or a precursor to something more serious, such as a global recession. In our view, given the resiliency of the U.S. economy, the prospects of the latter are highly unlikely. Moreover, only one of the last ten recessions since World War II was the result of rising oil prices, while the other nine have been linked to substantial interest rate increases to combat rising credit usage. Today we see neither a rise in oil prices nor an excessive credit build-up within the U.S. economy. On the contrary, U.S. corporations have become less leveraged and better capitalized. U.S. consumers have the lowest amount of debt, relative to income, in four years and oil prices have seemed to stabilize at the much lower than worrisome levels.
U.S. monetary policy-makers are firm in their commitment to cushion economic shocks. The Federal Reserve, in particular, is likely to be cautious in light of recent events and the absence of inflationary pressures as it assesses the timing and pace of any rate hikes.
Given the extraordinary gains in U.S. equities over the past seven years, the recent market dip was certainly long overdue. But we would disagree with pessimists’ opinions that a bear market has begun. In the past seven years, the bears were coming out of the woodwork with their “predictions” on many occasions, but each time the market has bounced back to new highs. Clearly, we cannot predict that U.S. equities will hit a new high next week, or even next month, but we can and will argue that the fears about a bear market are way overblown. We disagreed with the bear market forecasts back in 2011, when the S&P 500 Index fell by over 19% from April to October, and, even with the recent decline, the market is up 77.5% since then. Equally, we consider the 2015 correction not to be any different. If anything, it actually proved to be healthy. Market corrections and consolidations are part of the stock market experience. They have been, and always will be, part of investing in stocks.
Dumont & Blake Investment Advisors, LLC
September 30, 2015