Third Quarter Review

Third Quarter Review

Equities reached record breaking levels on multiple occasions for both the S&P 500 and the Dow Jones Industrial Average in the third quarter. The climb to these new highs was accompanied with some modest corrections. In August, the market experienced a three percent pullback from the July high and September had a three percent pullback from the September high. While the media hypes each down day as the coming of the next bear market, the market has had other ideas.

The strength of the financial markets is derived from solid fundamentals. From a macro viewpoint, data suggests the U.S. economy is stable and excepted to grow near three percent well into 2015. Emerging market economic growth is running a few percent ahead of the U.S. while Europe is a few percent points below our domestic growth rate. Modest growth with low inflation gives companies a stable backdrop for operating their business. This is evident in the expansion of corporate earnings over the past five years. It is not a coincidence that both the S&P 500 price and earnings are at record levels. These two charts of S&P 500 earnings best explain today’s stock prices.

Future earnings will drive future stock prices. Third quarter earnings and future earning guidance released in October and November will determine the trajectory and direction of future stock prices. We will monitor these earnings results closely in the coming months.

In the third quarter stock returns were generally flat. U.S. equities outperformed international stocks again and market volatility increased as the third quarter wound down. For the quarter, the NASDAQ, Dow Jones Industrial Average and the S&P 500 had positive results of 2.24, 1.87 and 1.13 percent respectively. The major international indices of MSCI EAFE and MSCI Emerging Markets had negative quarterly returns of -5.88 and -3.49 percent. Commodities were crushed during the quarter as many of the major commodities trade in U.S. dollars and the U.S. dollar strengthened against other currencies. Gold was down- 7.84 percent and oil price approached $90 a barrel at quarter end. Gasoline prices below $3.00 a gallon could give the U.S. economy a boost in the fourth quarter.

Interest rates remain in a very tight trading range despite the Federal Reserve winding down their latest Quantitative Easing program and telling the market to expect their five year zero interest rate policy to end sometime in 2015. The chart below, although it appears to show just one line, depicts the U.S. Treasury yield curve at June 30, 2014 and September 30, 2014. If you look closely, interest rates beyond ten years to maturity decreased ever so slightly and interest rates between one and ten years were fractionally higher.

Changes in interest rates directly affect bond prices. The relationship is an inverse one, so as interest rates move lower, bond prices move higher. The opposite is also true. U.S. Treasury Notes and Bonds are only affected by changes to the U.S. Treasury yield curve. Lower long term interest rates in the third quarter produced a 2.69 percent total return in the Barclays Long Term U.S. Treasury Index and the Barclays Intermediate U.S. was up a mere 0.02 percent during the quarter. For the credit sectors of the bond market including: mortgaged-backed securities, investment grade corporate bonds, and high yield corporate bonds; their prices are affected by both changes in Treasury interest rates and changes in credit spreads. Higher credit spread in both high yield and investment grade corporate bonds caused these sectors to be down -1.87 and -0.08 percent during the quarter. All in all, bonds have been remarkably stable in 2014 and we expect this to continue into 2015.

The fourth quarter will serve to set up the 2015 markets. Earnings momentum and continued economic growth are crucial to keep the ball moving forward. The naysayers are pointing to the October end of Quantitative Easing, increased geopolitical risk, a European recession, and future Fed rate hikes as reasons for the stock market to correct. We recognize the stock market is closer to full valuation and future earnings growth is needed to support current levels. We believe in the leadership and relative strength of U.S. companies and the economies in which they operate and remain positive over the long term. The fourth quarter will have some hurdles to clear, so don’t let any short term volatility derail your long term financial plan.

Posted on October 13, 2014
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