2014 4th Quarter Outlook
Review of third quarter
The capital markets provided mixed returns during the third quarter, as shown in the following table.
For the 3rd quarter, U.S. large company stocks increased in value by 1% -- the seventh consecutive quarter in which they’ve earned a positive return. But that was the only equity class that went up – small company stocks declined by 7%, developed international stocks fell by 6%, and emerging market stocks lost 3%. Bonds were flat – increasing in value 0.2%.
In the three weeks since the end of the quarter, stocks have been much more volatile. U.S. large company stocks have declined by 4% (as of October 17), and have had as many daily swings of at least 1% as in the previous five months combined.
Despite the uncertainty in the markets, the economic data are still robust. GDP data have been very favorable, and the economy is projected to continue to have real growth in the 2.5% to 3% range for the next few years. Inflation remains low. Unemployment dipped below the 6% level for the first time since the recession. There is strength beyond the main numbers. For example, the Purchasing Managers Index, a leading indicator of economic growth, has been at a consistently high level over the past few months, both in the U.S. and around the world. Borrowing at the corporate and personal level remains at a 35-year low. The economic situation in Europe has been stabilizing – over the past few months there have been higher profit margins, modest but positive revenue and earnings growth, and increased production and purchasing activity. Recently the International Monetary Fund revised its growth forecasts for Europe downward – however, unlike the past few years, growth for the rest of 2014 and 2015 is projected to be positive.
Stock Market Outlook
The key valuation measures for the U.S. stock market, such as stock-price-to-earnings, price-to-cash-flow, and market-value-to-book-value, are slightly below their long-term averages, which suggests the market is not overvalued. Because our economic outlook is positive, we believe the current level of prices in the U.S. stock market is well supported. Our eye is always on the long-term, and regardless of short-term
fluctuations, it seems to be a good time to remain invested in equities. While we do not think the large double-digit returns earned over the past few years will occur in the near future, there is no reason to expect a large decline. Because of the improving situation in Europe, we believe that developed market stocks will also provide good long-term prospects. And emerging markets, as always, have the highest growth prospects, the cheapest valuations, but also provide the greatest volatility.
Is Volatility Unusual
Every time stock prices fluctuate by more than a trivial amount, particularly if they decline, the financial press has a field day. Writers have to write, and there hasn’t been much to write about for the past three years because stock markets have been relatively stable. So the past couple of weeks have generated many financial headlines. As investors, we have to look to the past for guidance, and ask if this recent volatility is that unusual –the answer is no. Looking at the data over the past 40 years, the market has been as volatile as it currently is, or higher, 20% of the time. So while this is not an average occurrence, it is hardly “stop-the-presses” news. About 20% of the days in San Francisco are rainy, and yet, every time it rains we don’t see headlines screaming “FLOOD.”
In fact, the volatility we are currently experiencing is nearly identical to what happened in January and early February this year. The market fell by 6%, there were many days of market movements of more than 1%, and again, financial writers were telling us that this was the beginning of a market correction. And then, over the next eight months, stocks earned 14%, which took us to the end of September. We don’t know whether that will happen over the next eight months, but it’s as likely as the continued decline of the market.
Our outlook on bonds has been consistent over the past couple of years. There will likely be a rise in short-term rates over the next few years (the Federal Reserve forecasts a 3.5% increase in the Fed Funds rate), and a smaller increase in intermediate- and long-term rates. However, a long-term investor who is well diversified over short and intermediate maturities and various bond sectors will be well positioned to ride out the movements in bond prices.
Despite a recent increase in market volatility, the economic data is solid, and stocks seem to be are appropriately priced. The recent volatility is not unusual, and will likely have little effect on long-term investors. The data about the European economy is also favorable. We see no reason to deviate from a long-term investment strategy in equities. Investors should expect a rise in interest rates, but long-term investors should not shy away from a diversified bond portfolio.