Quarterly Review October 2015

Rocky Quarter The Pause That Refreshes?

There's no getting around it: last quarter was a bit like a Mad Hatter's tea party--or Mr. Toad's Wild Ride, if you prefer. Many factors converged to shake up the markets: China's surprise devaluation of their currency and their stock market's abrupt return to earth; concerns about US growth that cast the impending interest rate increase in limbo; oil prices declining below $40 per barrel; a selloff in biotech and healthcare stocks; concern about a global slowdown in economic activity. There are many things to point to as causes for the 6-week correction that took down the Dow Jones Industrial Average by 13.5% and the S&P 500 index by 11.9%.

Yet before all these converged, stocks had been flying high—reflecting the healthy second quarter economic growth rate of 3.9%. Technology stocks were at all time highs, bio-techs had maintained their course--soaring in the lofty, thin air of a long-term climb. Stocks had been the investment of choice compared to the paltry interest rates offered by bonds.

The better news is that, by the end of the quarter, stocks had partially recovered. This positive trend has continued into the current quarter, helping to bring the Dow back to a level that is just below where it was at the start of the third quarter.

Let's take a look at how various indices fared for the past quarter: 

​Index 3rd Quarter​ ​Year to date 2015
​Dow Jones Industrial Average (the Dow)
​- 7.6%
​- 8.6%
​S&P 500 Stock Index (the S&P 500)
​- 6.9% 
​- 6.7%
​NASDAQ Composite
​- 7.4%
​- 2.4%
​Russell 2000 (small companies)
​- 12.2%
​- 8.6%
​Dow Jones Global Stock Index (non-US)
​- 12.6%
​- 9.8%
​10-Year Treasury Bonds
​+ 3.0%
​+ 2.5%
​Commodities Index (Reuter-Jeffries CRB)
​- 13.3%
​- 11.6%
​U.S. Dollar Index (WSJ Index)
​+ 2.5% 
​+ 6.9%

All index values come from the Wall Street Journal. Stock indices do not include dividend return. All stock indices experienced quarterly losses, with large US companies faring the best. The more volatile small companies and international stocks had a rough go of it, as did commodities. During the quarter the price of crude oil dropped a colossal 24%, briefly dipping below $40 per barrel—the lowest price since 2009. The only two bright spots were bonds and the US dollar. Bonds were aided by the Fed's decision to leave interest rates alone and by increased demand for the stability that US government bonds offer. The dollar continued its advance in anticipation of an interest rate increase and as a safe harbor for international financial centers trying to protect their assets from currency weakness abroad. 

Although a clearly improving employment picture and the US economy's continued march at a healthy rate of growth has made us the envy of many, in the end concerns about the lack of global economic growth and low inflation made the Federal Reserve back away from nudging up short-term interest rates. Some market observers became suspicious that the Fed saw economic weakness that others didn't see. Then China sneezed and global markets caught a cold. Our stocks had already peaked in mid-July when the China markets began to tumble like a ton of bricks—which was long overdue. China stocks were ridiculously high priced, having been bid up to astronomic levels even as their economic growth rate was declining. In the second week of August China devalued their currency to protect their economy and support their competitiveness in international trade (aiming to increase exports and reduce imports). More serious selling occurred in our markets in August in response to a rout in the China markets. On August 8th, the Chinese stock index dropped 8.5% in a single day.

Where We Are Now

​The stock market has stabilized and it is possible that we have seen the type of correction that sets us up for future gains. The stock market correction served to wring out some of the excesses in the prices of stock but traditional measures of value (price-to-earnings ratio) are at or slightly ahead of long-term averages. Inflation has remained flat. Reduced energy costs have been offset by an increase in the cost of services. Employment has continued to improve this year, with the rate of unemployment down to 5.1%. Even with the distortions inherent in its calculation, it reflects ongoing improvement. Gains in employment have slowed in the past month or so. During the first week of October, 3-month Treasury bills were auctioned at ZERO yield for the first time on record. This is a free short-term loan to the US government, resulting from international demand--and demand from banks which are required to maintain government debt as part of their asset structure. Consumers have continued to support the economic cause by maintaining their spending at moderate levels, although a recent report noted that the growth of consumer's use of credit has slowed somewhat.

Looking Ahead

Market observers are split between those expecting the Fed to increase interest rates before the end of the year and those who don't expect any increase in rates this year due to lack of economic growth and a stagnant rate of inflation. Any change will be slight (0.25%) and not as significant as it is being portrayed. The International Monetary Fund (IMF) has lowered its forecast for world economies to 3.1% from 3.3%. This growth rate is also in line with forecasts for growth within the US. The IMF does not expect a global recession. The international rate of growth has declined steadily since 2011. Election season is ramping up. Republican candidates will be pared down over time. It will be interesting to see who will become the Chief Cat-Herder (Speaker of the House). With so much turmoil in the Republican party, that will not be an easy job. The absence of inflation has resulted in no increase in Social Security benefits in 2016. The annual federal government budget deficit is now lower than before the 2008 financial crisis, but it is still a deficit. Federal debt has grown 140% since 2007 (including the huge increase associated with the 2008 financial crisis). The federal debt as a percentage of the total economy has grown to nearly 73%--the highest level since the early 1950's when debt levels were recovering from WWII deficits. Low interest rates have subdued what would otherwise be an even greater problem. Now described as an "unsustainable fiscal path", important decisions must be made. Pay down the federal debt? It would be hard to find any politician serious (or brave) enough to tackle this problem in earnest—especially in an election year. The debt limit must be raised by early November to avoid the embarrassment caused by the federal government basically running out of money. This could become a political circus should the "tea party" use the issue to struggle for influence.

In spite of recent turmoil in the markets, we expect the economy to continue to grow modestly in a climate of low inflation and low interest rates. Though we are likely to experience some volatility, we expect the stock market to continue to recover.

As always, we will continue to follow the markets closely and take appropriate actions within client accounts to manage risk and return in accordance with each client's Investment Policy Statement.

Please feel free to call with any questions or comments.

Craig S. Limoges CFA, CFP, EA George Middleton CFA, CPA-PFS.

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