Quarterly Review October 2016

Can We Vote Early and Just Be Done With It?

The media is saturated with political coverage, displacing the reality of human existence. Sometimes you have to stake your claim on your own common sense and sanity by turning off all sources of media before you begin to think that the sunrises and sunsets are commanded by whatever one candidate has said about another. Not that it is unimportant, but it would be nice to just get this insane election year over with and move on. Regardless of the media's fanning of the flames of discontent, we will survive as we have in the past.

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)
​+ 2.1%
​+ 5.1%
​S&P 500 Stock Index (the S&P 500)
+ 3.3%
+ 6.1%
​NASDAQ Composite
​+ 9.7%
​+ 6.1%
​Russell 2000 (small companies)
​+ 8.7%
​+ 10.2%
​Dow Jones Global Stock Index (non-US)
+ 6.4%
+ 3.8%
​10-Year Treasury Bonds
​- 0.7%
​+ 7.3%
​Commodities Index (Reuter-Jeffries CRB)
​- 2.9%
​+ 17.3%
​U.S. Dollar Index (WSJ Index)
- 0.5%
- 4.2%

All index values come from the Wall Street Journal. Stock indices do not include dividend return..

​After advancing nicely in July, stocks held onto most of those gains through the quarter. While the more diversified, large-company indices of the Dow and the S&P 500 advanced moderately this past quarter, the tech-heavy NASDAQ and small companies (Russell 2000 index) notched big gains of nearly 10%. International stocks also did very well, making up for earlier losses. Treasury bonds lost a little ground, reflecting investors' anticipation of increased interest rates. Commodity values declined modestly but the index is up significantly for the year, reflecting the recovery of energy prices since the beginning of the year (oil has recovered to around $50 per barrel). The U.S. dollar declined somewhat, further increasing its year-to-date decline.

Where We Are Now

The economy has continued its path of slow growth with low inflation. Gains in employment have been encouraging. The traditional unemployment rate has held pretty steady and was at 5.0% in September--half the rate it was in 2009. This rate is a bit misleading. The unemployment rate reflects the percentage of those who are looking for work but are not employed. As more hiring has taken place, more idle workers have come off the sideline to look for work. Another yardstick is the "labor force participation rate". This reflects adults who are either employed or are seeking jobs. This has increased--reflecting an increase in the actual workforce as well as a growing number of workers who had previously given up and are now re-entering the hunt for jobs. Unemployment applications have declined to a 43-year low.

Consumer confidence reached a post-recession high in September. Accounting for two-thirds of overall economic activity, consumer spending has been a stalwart support of the economy. Though August was a flat month for consumer spending, early reports indicate September was better. Inflation remains quite low as overall price levels are only 1% above last year. As if on cue, it was recently announced that Social Security benefits in 2017 will rise a mere 0.3%.

Predictions for the growth rate for the recently completed quarter are better than previous quarters of the year. September retail sales rose after dipping in August. The increases were especially good for on-line retailers like Amazon.com, LL Bean, and others. Department store sales have slipped a noteworthy 6.4% since a year ago.

The current valuation of stocks remains high. This means that the price level of stocks is a bit ahead of what traditional measures say they should be, based on history. While this may imply an impending increase in earnings, the expectation is that--for the quarter just ended--profits of companies in the S&P 500 stock index are actually expected to decline, led by the energy sector. This would mark the sixth quarter in a row that profits have declined. How can stocks maintain their values when profits have declined? The answer may be: what else are you going to do with your cash? Put it in the bank and earn less than 1%? Invest in short-term bonds and get about the same return? Invest in longer-term bonds and risk the loss of principal that results when interest rates rise? This "investing in stocks by default" has been present in the markets and it's hard to see an end to it. Stock dividend yields remain far more attractive than bank account yields. There is no expectation for interest rates to increase at such a rate as to derail this logic.

Looking Ahead

Most economists (74% of those polled by the Wall Street Journal) expect the Federal Reserve ("the Fed) to increase short-term interest rates by .25% at their December 13-14 meeting. This has been long awaited and some would say overdue. The rate raise has probably already been priced into the markets. Confirmation of this has been a firming of the U.S. dollar early in October. Consensus opinion is that this increase is not the beginning of a series of aggressive interest rate increases. The economy is not robust enough and employment is not strong enough to warrant consistent future rate increases. This viewpoint has been echoed in recent statements made by Fed Chairwoman Janet Yellen.

November elections are looming and--depending on the outcome--may have interesting and direct effects on the markets. A Trump victory might be considered a surprise and may be accompanied by uncertainty about the future. A Clinton victory would cause less uncertainty and may result in a brief and modest "relief rally" in stocks. However, if a Clinton victory were accompanied by Democrats regaining control of both the Senate and the House, that type of majority power is seen to have the potential for changes that are averse to corporate earnings—a recipe for market decline. If Republicans at least hold the House, that balance of power is seen by some pundits as better than concentration of power in one political party.

For now, it appears that consumer spending is steady and will continue to support modest economic growth. Modest gains in employment appear to be sustainable although perhaps at a lesser rate of improvement than recent months. There is no apparent pressure on prices and low inflation is seen as healthy. Although the Fed is likely to raise interest rates in December, it is unlikely that banks will raise the rates paid to depositors by the same amount. This dynamic (low bank rates for depositors) will continue to provide support for the prices of stocks and short-term bonds. Unless the final chapter of the political circus leading up to elections holds some sort of remarkable surprise, the outcome may have only a short-term impact on broad stock prices. Some sectors may see a decline due to promises made by the prevailing candidate while other sectors may gain. The environment we currently enjoy--slow but consistent growth with low inflation--continues to be positive for financial assets.

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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