The third quarter of 2013 has come to a close and although September is historically a down month for the stock market, the quarter ended on a positive note. The S&P 500 index rose 3.14% for the month of September and posted a year–to-date gain of 19.8%. The performance of the NASDAQ composite was even more impressive, showing a year- to-date gain of 26.1%. Every sector of the S&P 500 is positive for the year. Even the MSCI EFA Index, which tracks worldwide developed markets, is up 13.4% year-to-date. In a month where some feared the Federal Reserve’s actions (or in this case, inaction) might disrupt the markets, the positive results proved otherwise.
The September meeting of the FOMC resulted in the Federal Reserve continuing its Quantitative Easing and confirming its decision to not start tapering. The basis of this decision, as with previous ones, was the data, with the emphasis on the labor market. Bernanke was quite clear back in the spring that should economic indicators show enough strength, the FOMC would consider tapering earlier than planned. How the markets took that to mean tapering would start in September, we cannot say. We have always taken the view that the Federal Reserve would stay on the current path until the data showed enough strength in employment and the economy, just as Bernanke has always stated. Another important point to mention is the reaffirmation of the Federal Reserve’s view that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In other words, keeping the Federal Funds rate low (currently 0 – ¼ percent) for a much longer period of time.
Frankly, we were surprised the market did not react more strongly to the downside after Ben Bernanke explained the Fed’s concern of the economy being more at risk for stalling, especially with unemployment rates remaining elevated and tightening financial conditions, if sustained, slowing the pace of economic improvement. The committee needs to see more data supporting progress before adjusting purchases. Inflation is still below its 2% objective and the unemployment rate is not coming down as much as most hoped.
Going into the fourth quarter we expect some market pullback. The S&P 500 produced double digit returns for the last two years in spite of a still tepid economy. Our longer term outlook for the market remains positive. There will continue to be hurdles from the slowdown in Europe, crisis in the Middle East and, of course, our own issues here in the United States. However, that being said, longer term the outlook for our economy, and the world’s, stands to only improve. As we have said, time and time again, our economy is just muddling along and yet, companies are flush with cash and still making new earnings highs. Your portfolios are positioned accordingly as the cash levels are near their highest allocation which dampens volatility from stock market corrections and interest rate spikes. More importantly, it gives us opportunities to buy on stock dips and lock in bond coupons if interest rates move higher.
For the first time in 21 years bearish and bullish forces were balanced during an unusually flat and “boring” summer of 2013. Giving way to fall, investors were bracing for a rocky road ahead, sensing the bears’ impatience for a catalyst to spark a real sell-off. However, the closing bell on the last market session of September, the month that is traditionally perceived as the worst one for Wall Street, signaled yet another triumph for the bulls as all major indices ended the month and the quarter in the green. The Dow Jones Industrial Average gained 2.1%, the S&P 500 Index rose by 5.2% and the NASDAQ Composite jumped 11.2% during the third quarter. Year-to-date returns were very encouraging with the Dow up 17.3%, NASDAQ up 26.1%, and the S&P 500 up 19.8%. All sectors of the S&P 500 Index produced positive returns year to date, although the pro-cyclical group (Industrials, Basic Materials, Consumer Products and Services) have outperformed the defensive ones. The Russell 2000 Index of small and medium size companies was the best performer so far this year, reaching a commendable 27.8% return after spiking 10.2% during the last quarter. International equities were also positive for the quarter with the MSCI EFA Index that includes worldwide developed markets advancing 10.9% for the quarter and 13.4% year-to-date. While the MSCI Emerging Markets Equity Index was up 8.3% for the quarter, it remains down 7.6% for the year. Fixed income indices were mixed with the Barclays Capital Aggregate Total Return Bond Index up 0.6% for the quarter but down 1.9% for the year, while interest rates on 10-Year U.S. Treasury Notes, after briefly topping the key 3.0% level on September 5th, ended the quarter back where they started in the 2.5-2.7% range.
Overall, it was a good quarter – and year so far – to invest in equities despite all the concerns over job growth, unemployment being stuck above 7%, The Federal Reserve’s talk of “tapering” its bond purchase program, an ongoing battle over funding of the Affordable Care Act and a full plate of Syria-centered geopolitical tension.
The state of the domestic economy appeared somewhat healthier than earlier believed. In the Bureau of Economic Analysis’ second estimate, real Gross Domestic Product growth for the second quarter was raised to an annualized rate of 2.5% compared to the initial estimate of 1.7% and a first quarter rise of 1.1%. U.S. financial conditions have improved noticeably, following a brief period of increased concerns in the second quarter. In addition to mortgages, banks have experienced increasing demand for all types of loans, according to the latest Fed survey. The corporate sector remained solid, as the July Manufacturing Purchasing Managers’ Index (PMI) revealed the strongest rebound in new orders since 2011. Although the earnings growth slowed to some extent, an improved outlook for capital spending outlines a productive environment for the corporate sector overall. The labor market continued its modest pace of repair, with four-week average numbers for unemployment claims and the unemployment rate falling to new post-recession lows. Consumer spending has been growing at a steady pace and consumer confidence indicators remain near post-recession highs even after softening mildly following an incremental lift in interest rates. Pricing pressure, as measured by CPI, is rising gradually but remains well contained. Residential housing remains constructive to U.S. economic growth. Though permit issuance and housing starts have moderated from the increases seen earlier, both continue to post respectably high year-over-year growth. Whereas rising interest rates may create some drag for the housing market, the continued rise of employment and decent improvements in mortgage availability from extremely tight levels may offset some of that effect. Clearly the rapid pace of price acceleration is likely to slow, but the tight supply of existing homes that remains near cycle lows combined with the growing number of household formations, as a result of the rise in employment, supports a long-term positive outlook.
Our outlook for the economy and the markets remains steadfast. Since the end of the recession, and in line with our expectations, the United States economy advanced in its below-trend growth mode and Europe has been caught up in its own recession and debt burdens. Growth has slowed in most of the emerging markets, ending the commodity boom of the first decade of this century. Interest rates, though no longer at the “lowest ever” levels, are still showing no sign of inflation on the horizon, and the Fed is unlikely to raise rates in light of improving, but still relatively high, unemployment. The U.S. stock market has continued its unprecedented upward move with the help of Quantitative Easing and strong corporate earnings growth. And, in the meantime, as the events of the first few days of the last quarter of 2013 illustrate, the most dysfunctional aspect of the U.S. economy appears to be the U.S. government itself. The “Great Recession”, followed by stimulus, bailouts, “Cash for Clunkers”, unemployment extensions and other numerous Keynesian measures paid for by running up the federal credit card raised the deficit to $1.4 trillion or 10% of GDP. The good news is that the “lame duck” presidency and the Congressional gridlock mean the end of this spending spree. Washington is now experiencing one of the biggest fiscal retrenchments in modern history and the deficit is expected to fall to $600 billion and 4% of GDP. While this trend is encouraging, the degree of discord, inflexibility and bitterness in both parties are reaching the levels that are extreme, even by Washington’s standards. We fully expect the continuing discussions over the debt ceiling, the Affordable Care Act’s funding, and the government shutdown will dominate headlines near term. Fortunately, over the past years, the stock market has proved its ability to look beyond noise and focus on the underlying fundamentals of the economy going forward.
Dumont & Blake Investment Advisors, LLC
September 30, 2013