The stock market stumbled near the end of the third quarter, however, the S & P Index was up 6.7% year to date. The average diversified equity fund was up 3.2% for the year and was down about -2% in the third quarter.
3rd Quarter Results:
Despite the fact that 2nd quarter GDP increased by 4.2% and the S&P 500 and the DOW hit all-time records, the overall stock market was negative for the third quarter. Much of this was due to the performance of small company stocks which were negative for the quarter and are now down -4.4% for the year.
The strong performance of small-cap stocks in 2013 left many valuations of these small stocks at historical highs. The Russell 2000, the benchmark for small-cap stocks, had a price/earnings ratio of nearly 20 times at the end of last year. This is substantially higher than the 16.9 times earnings since 1994. This makes smaller companies more costly relative to future earnings versus larger company stocks and thus less attractive.
Investors remain concerned about rate increases by the Federal Reserve. During previous stock market declines triggered by rate increases, small stocks fell an average 13% while large-cap stocks fell 9%. Small companies are harder pressed than larger company to find financing when rates rise and the capital markets tighten. The threat of rate increases is a main reason investors have been heading for the exit, pulling $15 billion from U.S. small-stock mutual fund this year. This compares to an increase of $22.6 billion in 2013.
Investors received a variety of signals during the quarter that the U.S. economy was picking up speed in the second half of the year. Labor market data was especially strong with payroll statistics reaching their most favorable levels since the late 1990s. The manufacturing sector remained robust, while a better job market and rising consumer spending appeared to drive healthy growth in the much larger service sector. Investors were also relieved to see evidence that the housing sector had regained traction as homebuyers reconciled themselves to somewhat higher home prices and mortgage rates.
Investors were also encouraged that corporations had been able to leverage moderate economic growth earlier in the year into faster profit growth. A generally positive tone to earnings reports helped provide momentum to the market at the start of the third quarter. Overall earnings for companies in the S&P 500 had increased by 7.7% in the second quarter, well above the 4.9% growth expected. Moreover, nearly three quarters of companies’ earnings surpassed analysts’ estimates.
Investors kept a wary eye on how the Federal Reserve would react to the improved economic date. Some worried that the strength in the labor market might cause the central bank to signal an increase in short-term rates sooner than anticipated, and markets pulled back periodically throughout the quarter because of this. Policymakers put these fears to rest at their September policy meeting by signaling no substantial change in their interest forecast which may have been a catalyst in pushing stocks to record highs near the middle of the month.
While rate increase remained a future threat, healthy U.S. economic growth had a more immediate impact on the U.S. dollar which also concerned investors. Weaker economic signals from Europe helped the dollar reach a two-year high against the euro while aggressive monetary policy in Japan took the yen to a six-year low against the greenback. The escalating crises in Ukraine and the Middle East also weighed on non-U.S stocks and fed demand for the perceived safe haven of the U.S. dollar. Energy and materials stocks declined as the stronger greenback weighed on dollar-denominated commodity prices and oil prices.
More broadly, investors worried that the rising dollar would make goods produced in the U.S. less competitive overseas. In addition over 40% of large U.S. company earnings come from overseas sales. A strong dollar means these earnings are worth less when they are converted from their foreign currency into U.S. dollars. Near the end of the quarter the concerns of slower European and Chinese growth led to a decline in stock prices.
End of the Year:
Four of the five previous bull markets since 1970 ended as investors got spooked by a recession or the anticipation of one. What caused these recessions? In three of the past five, it was the Federal Reserve hiking interest rates to slow inflation. Typically though, the problems for the economy and stock market don’t come until after the Fed has hiked rates a number of times, not early in the process. Eventually, higher rates put a brake on the economy and crimp earnings, prompting investors to sell stocks.
The last cycle of rate hikes topped out at 5.25% with the final increase coming in June 2006. Stocks peaked in October of the following year. Some worry, however, that the next hikes will defy historical patterns because of the Fed’s unprecedented stimulus. Once the central bank ends its third round of quantitative easing after its next meeting in late October, its balance sheet will stand at close to $4.5 trillion. That is about five times its size from before the financial crisis.
It has been a very bad start to the fourth quarter for equities and commodities. Setting off the declines was more bad economic news out of Germany combined with a report from the IMF that again reduced its forecasts for worldwide growth. While the report wasn’t exactly new information, it was a catalyst for investors that had already grown a bit weary of high valuations. Stock earnings per share are 19 times which is higher than historical norms of 15 times.
Falling oil prices didn’t help that sector of the market. While lower oil prices are generally good for consumers because of lower gasoline costs, prices have now fallen enough to potentially slow the U.S oil boom. Worse, falling oil could begin to really squeeze Russia, which could cause them to make even more provocative maneuvers on the world stage.
The IMF (International Monetary Fund) releases one or more comprehensive forecasts of global economic growth several times a year. Markets seemed to take the new report as some kind of shocking revelation. Overall, the report now predicts just 3.3% growth in 2014 and 3.8% for 2015, down 0.1% and 0.2% respectively from the last report in July.
With just 13% of U.S. growth dependent on exports, the U.S. is much less exposed to slowing world GDP growth than most other countries that typically get a third or so of their DDP from exports
Many believe that U.S. stock prices are likely to move more in line with earnings growth rather than through an expansion of valuations or how much investors are willing to pay for a dollar of those earnings (expansion of the P/E multiple). Valuations may no longer be cheap but neither are they out of line with the pattern of the past two decades. Faster-growing, higher-valued growth stocks are generally less expensive relative to historical patterns than value shares and large-caps appear to be cheaper than small-caps. Overall, stocks also appear cheap relative to bonds which may provide support to equities if interest rates increase and investors move away from fixed income.
Small-cap funds have been the biggest disappointment so far in 2014. They were down 4.4% through September. We had sold some of the small-cap positions in the first quarter as a safety precaution which was a good move. Small-caps were up 37% in 2013, beating all other sectors. They have outperformed large-cap stocks for the past several years and Wall Street is sensing that we are reverting to the mean, e.g. slowing small-cap stocks to the better returns of larger-cap funds. If markets do not improve soon, we will sell more of the small-cap and mid-cap funds and move them into safer areas. Client portfolios remain diversified, however, with the vast majority of assets in large-cap funds. This remains the safer place to be for equities.
There is a general discouragement in this country as to whether the U.S. is on the right track going forward. The problems we are facing as a nation including Ebola, the Middle East, Russia, and a slow-growing economy has investors worried about the stock market and its progress.
We are generally optimistic relative to the market. However, recent trends make us more concerned about stock direction. We will make necessary adjustments as we move into the final three months of the year.
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