3rd Qtr Portfolio & Market Observations 2014

The third quarter of 2014 was challenging to say the least. After a prolonged period of unusual tranquility, volatility returned to financial markets in early summer. Investors’ appetite for risk took a dent, the growth momentum was increasingly absent and geopolitical events including the downing of Malaysian Airlines’ MH17, the potential spread of the Ebola epidemic, and the “rise” of ISIS weighed on investors’ sentiment.

Framed by a feeble July and an especially weak September, the S&P 500 Index managed to grow by 1.1% in the last three months with the help of very strong returns in the month of August. Thus, the record streak of consecutive quarterly advances was extended to seven and the year-to-date performance of the S&P 500 grew to 8.3%. The Dow Jones Industrial Average added 2.9% during the third quarter and advanced 4.6% for the year. The NASDAQ Composite Index expanded by 2.2% and 8.6% for the quarter and the year respectively. On the other hand, the riskier Russell 2000 Index of small capitalization companies took a 7.4% dive during the third quarter and posted a 4.4% loss year-to-date.

International markets continued to express the most glaring inter-market divergences of past months, significantly underperforming U.S. equities on a relative basis. The MSCI EAFE Index ended down 3.6% year-to-date after the 6.4% plunge in the last quarter. During the same time the Emerging Markets Index declined 9.0%, ending the first nine months of 2014 with a loss of 7.7%.

The fixed income market held steady. As the yield on 10-Year U.S. Treasury notes hovered around 2.5% from the beginning of July to the end of September, the Barclays U.S. Aggregate Bond Index finished the quarter virtually flat at .2%, edging its year-to-date performance to 4.1%.

The Economy

The U.S. economy expanded more than previously forecasted in the second quarter, as August government data showed Gross Domestic Product, propelled by the biggest gain in business investment in more than two years, grew 4.2% annualized, accelerating from an initial estimate of 4.0%.

Factory orders rose significantly during the third quarter of 2014 with aircraft orders being the biggest influence. The Conference Board’s leading economic index showed a 0.2% gain for August after an increase of 1.1% in July. While it is unlikely that the domestic economy will repeat its stellar second quarter performance in the second half of 2014, it is obvious that it is continuing to gain traction.

According to the latest U.S. Labor Department data, employers added 248,000 jobs in September. In addition, job numbers for previous months were revised upward, and the jobless rate fell to 5.9% from August’s 6.1%. These numbers had the mainstream media cheering that “economic victory” was imminent and stocks propelled upward.

Consumer Confidence hit a 14-month peak in September, as the preliminary Thomson Reuters/University of Michigan Consumer Sentiment Index read 84.6, reaching its highest level in over a year. Household income expectations also hit a six year high, fueled by Americans’ strong perception of present economic conditions. Consumers’ summer spending spree lifted retail sales, and they increased in August, easing some anxieties about a possible slowdown in personal spending.

Economic momentum was also evident in select areas of the U.S. housing recovery, as existing home sales rose to the highest level in 10 months in July. New residential construction jumped 15.7%, soaring past market expectations and ending two months of declines. New home sales, however, lagged other housing indicators as they fell 2.4% in July in a second consecutive monthly decline. Sales were still 12.3% above their July 2013 level, and median prices grew by 3.0%.

The U.S. Federal Reserve did as expected in the September policy meeting by continuing to reduce its quantitative easing (QE) program by $10 billion a month. At the next meeting in October, the expectation is that it will move out of QE entirely. The Fed also retained its accommodative stance toward rising interest rates as was expected by the market.

The market was looking for the Fed to remove the phrase “considerable time period,” which refers to the start of rising rates, however, the Fed kept that language. U.S. Federal Reserve Chair Janet Yellen made a point to note that even though the unemployment rate continues to come down, the Fed views slack in the labor market as still being an issue.

The Fed continues to be very positive about the rate of inflation, believing it will continue to be benign.

Outlook

The market run-up, post the financial crisis of 2007-2008, has entered its sixth year now and has become the fourth-longest bull market in U.S. history. Since the market bottom in March 2009, the S&P 500 has risen 202.2% through the end of September 2014. While investors have to be pleased with that kind of advance, questioning where the market goes from here is only natural. Whispers of a looming recession emerged in the second half of 2013, and have lingered. Suddenly more and more stockholders, not having experienced a 10% correction in three years and looking for signs of a top in the market, are starting to get an itchy finger and acting on every piece of news about the global economy and political unrest.

All of this has increased volatility for 2014. The stock market was off to a tough start in January and went through frequent small pullbacks. After months of setting new record highs and basically tripling off the March 2009 lows, the market appears to have run out of a little steam over the past few weeks. Stocks are not cheap and it is probable that market volatility is here to stay as the capital markets continues to wrestle with a series of counterforces. However, the stealth bull market no one believes in portends more upside, as the strengthening economy, low inflation and steepening yield curve strongly suggest that U.S. and global equities will continue to advance by year-end. In addition, traditional “safe haven” assets, such as short to intermediate duration U.S. Treasuries, may actually be the most vulnerable as a period of rate normalization approaches. Especially in today’s environment, high quality bonds, CDs and money market funds just can’t offer enough income for one to live on. Therefore, at the present time, we believe that equities should constitute a larger than average percentage of our clients’ portfolios.

Dumont & Blake Investment Advisors, LLC

September 30, 2014

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