Review of 3rd Quarter
In our outlook from last quarter, we warned that despite having enjoyed ten successive quarters in which the S&P 500 gained value, "we’re likely to see somewhat higher volatility and occasional market declines." Certainly we saw a great deal of volatility – some of it logically based, and some that’s hard to explain. The understandable reason for concern was the potential for a global slowdown in growth, particularly stemming from China.
When we look at the raw numbers, the market returns don’t seem too bad. The S&P 500 declined by 6%, and most bond indexes either held stable or increased slightly. And yet, the third quarter “felt” worse. There are a few reasons for that:
From the highest point (July 17) to the lowest (September 28), the S&P 500 declined by 12%
Other equity indexes fared worse during the quarter than the S&P 500 – small cap stocks declined by 12% and emerging market stocks fell by 18%
The extreme daily (and even hourly) volatility drew our attention to the markets
The press focused attention on the declines
Towards the end of the quarter, markets started to stabilize – between September 28 and last Friday (October 9), the S&P rose by 7%.
Below is a table showing key economic and market indicators (as of September 30)*:
**Sources: Bureau of Economic Analysis, Bureau of Labor Statistics, JP Morgan, Federal Reserve Board
If you had not read any news over the past three months, you’d likely look at those numbers – low inflation, declining unemployment, low interest rates, and steady growth – and believe it must be a good time to be an investor in the U.S. The recent market volatility has been caused by concern about non-U.S. economies and not our domestic economy. But while all countries have business interests that are linked, the U.S. indicators remain strong.
U.S. Stock Market Outlook
Despite last quarter’s market downturn, there are several positive signs. Domestic signals point to a solid economy. Moreover, a benefit of the recent decline is that market values are lower, and because earnings have remained strong, the price-earnings ratio is below its long-term average, which means stocks are cheaper than average. There are likely to be three main drivers of returns over the next three months:
Earnings: The biggest Impact on returns will be over the next few weeks as companies begin to announce their third quarter earnings. Analysts will particularly focus on any signs of the feared global economic slowdown.
Interest rates: The best indicator of how the market feels about interest rate changes can be seen by looking at the hourly stock index movements on September 17, the last time the Fed made an announcement. Throughout the day, most analysts expected the Fed to increase interest rates slightly, and the S&P 500 steadily rose by about 1% throughout the day. Late in the afternoon the Fed announced that they were not increasing rates, the S&P 500 declined by the same 1%. We do not think that a small increase in rates will cause the market to react negatively, in part because analysts have been expecting it for a long time. Also, the Fed has committed to an accommodative monetary policy and, even when rates are raised, they will likely remain low by historical standards.
- China: Last quarter was evidence that not only is the Chinese market erratic, but analysts’ conclusions about how the Chinese market and economy will impact the rest of the world are also unpredictable. While the market has been less reactive over the past month, China remains a concern going forward.
Most bond managers we speak with are confused. They had been anticipating the Fed’s interest rate increase to have already occurred, so their own forecasts going forward are clouded. We continue to recommend broad diversification and a focus on short and intermediate term maturities.
We forecasted last quarter a high degree of volatility for non-U.S. stocks, and unfortunately, we were correct. That volatility should be diminished going forward, and if domestic stocks are cheap, international stocks are even cheaper. We recommend continued investment in an internationally diversified portfolio.
As advisors, one thing we’ve noticed is a consistent calmness about the recent market volatility across our clients. That’s likely because most of you have been our clients for many years. You’ve been through the horrible downturn of 2008, and heeded our advice to stay the course. You remember the overreactions to the European crisis of 2011 and stuck with the plan. As we mentioned in our commentary of August 24, the worst thing an investor can do is to sell at the bottom of a market. Since that day, the S&P 500 has risen by over 6%. We continue to believe that maintaining a consistent investment strategy is a key to long-term success.