3rd Qtr Portfolio & Market Observations 2016

The third quarter of 2016 had something for everyone. In July, an initially negative market reaction to the surprising Brexit vote passed quickly and the bulls rejoiced as the markets climbed to multiple record highs after Brexit concerns quickly paled. In August, the markets displayed their typical summer sluggishness with low volatility, sideways price action and tight trading ranges. In September, the bears briefly thrust their heads up when the speculation of an interest rate hike caused a mild pullback. But in the end, the markets once again proved their resiliency and U.S. equities strengthened in the third quarter. The S&P 500 Index gained 3.85%, which brought the year-to-date performance of the index to 7.84%.

The Dow Jones Industrial Average rose by 2.78% for the quarter and 7.21% for the year. The Nasdaq Composite Index added 10.02% during the last quarter and thus erased the first six month’s loss, standing at 7.15% year-to-date on September 30th. The S&P 400 Mid Cap Index and the Russell 2000 Index of small companies fared better than their large-capitalization counterparts. S&P 400 rose by 4.14% for the quarter and 12.40% year-to-date while the Russell 2000 rose 9.05% for the quarter and 11.45% year-to-date.

The global markets also delivered a strong performance. The MSCI EAFE Index that measures the performance of the world’s developed countries markets was up by 5.80%, narrowing the year-to-date loss to -0.85%. Emerging markets grew by 8.32% for the last three months and 13.77% for the year.

The bond markets were strikingly calm in the third quarter, particularly when compared to the tumultuous final week of June. The Barclay’s U.S. Aggregate Bond Index booked a 0.46% increase in the last quarter, standing at 5.80% for the year on September 30th. The 10-year Treasury yield rose from 1.47% at the beginning of the quarter to 1.60% by the quarter’s end, after hitting a high of 1.73% in mid-September amid the rate-hike rumors. Although short-term rates have increased slightly over the past year, fueled by the Fed Funds rate increase in December, medium and long-term yields have declined over the past three years, causing the yield curve to flatten, reflecting the same continued theme of uncertainty.

The Economy

Economic data has been mixed, at best, during the last three months. We have seen signs of the potential weakening of auto sales and softer than expected housing data. The Institute of Supply Management and the Chicago Fed’s National Activity Index, both measuring the level of manufacturing activity, came in below expectations.

Job creation edged lower, as employers only added 156,000 new jobs in August versus an expected 176,000, and the unemployment level ticked up to 5.0% even in light of a record number of Americans leaving the workforce.

Other economic news was not that murky. Real Gross Domestic Product increased at an annual rate of 1.4% in the second quarter of 2016 according to the third and final estimate released by the Bureau of Economic Analysis in September. While the U.S. economy seems to not be able to escape this narrow 1-2% range of growth for the last few years, the last reported number, however, was much better than previously estimated.

Consumers also grew more optimistic as the quarter progressed with the University of Michigan’s monthly reading of households’ sentiment rising slightly from July to September.

In August, Federal Reserve officials, including current Chair Janet Yellen, appeared to be setting the stage for a September rate hike. However, in light of the softness of some recent economic data, the Federal Open Market Committee did not raise the federal funds rate at its last policy meeting but decided to wait for “further evidence”. More importantly, officials’ expectations of future rate hikes turned shallower, as officials foresaw a lower path of rate hikes in 2017 and 2018 than they did three months earlier.

Outlook

Traditionally, the third quarter holds the dubious distinction of being the poorest performer of the year. Yet this year the markets posted solid gains in this time period, and more impressively, marked four consecutive positive quarters, as well as thirteen positive quarters out of the past fifteen. One would have to go back to the mid-90s to find the last time a similar streak occurred. However, an important thing to note is that we are entering the last three months of the year, which historically have been the strongest going back to the 1950’s. What could drive the upcoming quarter away from the time-proven standards?

Of course, the political factor, and by far the biggest event for investors to consider in the fourth quarter, is the U.S. Presidential election. While the markets are expressing anxiety at the increased certainty of a Clinton presidency in early October, the race is still close enough for the elevated volatility to continue until November 9th. Once the significant policy uncertainty is lifted, businesses can go on with the major decisions such as capital investment and hiring.

The economic factor that may affect the market performance in the near future lies with corporate earnings and the actions of the Federal Reserve. After five consecutive quarters of stagnant growth in corporate earnings, it is hard to overestimate the importance of the coming earnings season. If earnings disappoint, the market could be vulnerable. However, if a significant number of companies beat the consensus’s low expectations, we could see a pattern of renewed steady earnings growth fueling new record highs for the equity markets.

While the majority of Fed officials did not see sufficient economic evidence to warrant an increase in September, the minutes from its September meeting strengthened expectations that the Fed may raise rates at its final meeting of the year in December. So far, at least, that message has negatively impacted the markets, but an expectation of potentially higher rates can once again lead to volatility.

The economic expansion that started back in 2009 has been one of the longest on record, but the slow and steady pace of growth has not yet led to any of the typical imbalances usually signaling its end. Expansions don’t die of old age, but because of significantly tighter monetary conditions or some sort of economic or financial shock, and we don’t see either of those conditions in place at this time. Moreover, our domestic economy is relatively self-contained due to its size and wealth, and, unlike most of the world, is much less vulnerable to global economic cataclysms.

Therefore, we believe the bull market that started back in March of 2009 is still intact, regardless of numerous voiced opinion pieces that attempt to draw some parallels between the way the market acted in October 1987 and the way it is acting now. We can recall the markets’ action in June of this year, when markets dropped more than 5%, or last December to January, when the markets fell nearly 12%. As those drops show, a pullback doesn’t necessarily mean a bear market. In fact, in both cases, the pullback set the stage for a stronger move up. Even after the 1987 decline, as terrifying as it was, the market returned to new highs within a year. Pullbacks are normal; big drops are less normal but still not uncommon. When we see calls for a 1987-type event, we draw two conclusions: first, the markets are still worrying, which is actually a good sign, and second, because of that worry, a long-term pullback is much less likely. If we do get a repeat of 1987, it would likely be short lived and a buying opportunity—or, in other words, a pullback. Right now, economic conditions are such that any drop is very likely to be just that rather than something worse.

Dumont & Blake Investment Advisors, LLC
September 30, 2016

 

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