Third Quarter 2015 Update

The third quarter of 2015 produced poor stock performance, with all three major indexes inking losses of around 7%. The S&P 500 actually performed best out of the three, but performance was very similar among all three indexes. These losses were certainly not what the majority of investors expected, and the result was a reversal of fortunes for the S&P 500 and Nasdaq Composite for the calendar year (to-date), with the Dow having already turned negative for the year prior to the start of the third quarter. All eyes are on the Fed, and with one meeting remaining in 2015 (December), analysts and economists are divided as to when they believe the Fed will raise rates.

The Fed

The Fed has held interest rates at or near zero percent on the short end of the curve since December of 2008, or for almost seven years. The most recent Fed meeting revealed that the Fed is concerned about inflation and will therefore push ahead with the first rate hike in the near-term. The latest jobs report—released Friday, October 2, 2015—showed just 164,000 new jobs were added and that the rate of unemployment held steady at 5.1%. This report was viewed as a major negative for the U.S. economy, but also as a good excuse for the Fed to delay their first rate hike, possibly until sometime in early 2016. Stocks, as a result, have rallied somewhat.

The probability for Fed action in December dropped dramatically after the jobs report—about a 29% chance at the December meeting. This prediction, based on the Fed Funds futures, was at 44% for December before the jobs report was released.

I still feel that there is a greater chance of Fed action by the end of this year than most are predicting, and do not feel that the Fed places much weight on a single report; jobs or otherwise. They are looking at major economic trends, and are far less focused on stock market performance than investors believe (or hope). In short, it is not the Fed’s mandate to drive positive stock market performance, but rather to support full employment and stable economic growth. With this in mind, it makes more sense to me that they will look at the long-term threat of inflation, and the stability of GDP growth going forward, when determining when to raise rates. My feeling is that investors are far too focused on the timing of the first rate increase, rather than focusing on the pace of the rate increases, once they begin. With this stated, the first rate hike will certainly impact financial markets significantly.

Bonds

Interest rates are basically right where they began 2015, although they have been somewhat volatile throughout the year. We saw rates driving higher in the middle of the year, from mid-Q2 through early Q3, up to about 2.5% before retreating to the current 2% yield (10-year treasury note).

The yield curve is still relatively flat, although the short-term segment appears to have a steeper curve because of the Fed’s manipulation of the short end of the curve—holding short rates at zero percent. Once they begin raising rates we should see the entire curve move higher, and I would expect to see the short end flatten and the longer end steepen a bit. There are a few reasons for this, but in general investors will likely sell the longer-end of the curve since rising rates tends to make existing bonds less attractive as new bonds will offer higher yields, and foreign investors will receive less in return as the dollar strengthens with rising rates.

Stocks

As stated above, stocks had a bad quarter, and it was the worst performance for stocks during any quarter since before the bull market began in early 2009. All three major indexes lost significant ground – about 7% during the third quarter – with the Dow performing worst out of the three major indexes.

The Russell 2000 small-cap index, performed even worse, with that index down 12.2% for the third quarter, and down 8.6% year-to-date. Small-cap stocks tend to be the first to move, providing a preview of market direction whenever the market is about to change directions.

We have not had two quarters in a row of relatively poor stock performance, so it is becoming more likely that the overall stock market has changed directions, and is at least in a correction phase, if not a bear market.

On a sector basis, we saw a broad spectrum of performance results, although all but one sector suffered losses in the third quarter. The most pronounced drops occurred in Materials (down 17.5% during the Q), and Energy (down 18.57% during the Q). The Utilities sector was the only positive performing sector (up 4.41%).

On a year-to-date basis all sectors lost ground except for Consumer Discretionary (up 2.92%). Materials and Energy took the biggest hits on a year-to-date basis, down 17.83% and 22.69% respectively. All in all, the quarter and year-to-date performance of the broad market, as evidenced by the individual sector performance values, was ugly.

Looking Ahead

I continue to wait and watch, with the expectation that markets will once again test the same levels and possibly decline even further, offering an attractive opportunity to enter the market at very favorable price levels, reducing risk and offering strong upside potential for the overall portfolio.

Markets have been rallying since the start to the fourth quarter, after the jobs report and expectations for a Fed rate increase in 2015 have faded. I still feel it is likely that the Fed will want to get the first raise on the books sooner rather than later, which ironically I believe would be better for the markets in the long-run (even though investors will likely crush stocks when it happens).

The uncertainty surrounding the first rate hike is making it far worse for financial markets than the actual rate hike will be—as soon as the Fed announces the first hike, and market react, I feel the markets will stabilize, and investors will be able to look ahead at the trend of rate increases, which should be at a measured, slow predictable pace.

Regardless of the timing of the first rate hike, I firmly believe there will be an opportunity for moving money back into stocks at good price levels before the end of 2015. I am closely monitoring all markets around the globe, and stand ready to take action when timing and pricing are attractive. The recent rally sets up the possibility of another significant shunt in the markets, especially if the Fed decides to hike rates in the near-term.

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