The stock market along with the full force of the financial media rendered its version of shock and awe on unwitting investors; paralyzing some and forcing others into an early surrender. We strive to keep our independent advisors and their clients informed and provide non-emotional clarity to the news and events that matter. October proved to be a stern test of investor resolve as volatility spiked and stock prices fell quickly, only to rally back with vengeance.

Let’s put October into perspective. The stock market has been rallying for over five years and the rally will likely continue given the corporate earnings expectations and current price earnings multiples. Stock markets do not go straight up, although the past two years is as close as we can get to nirvana.

The stock market corrects within every year and over the long haul it averages 2.6 positive calendar years for every one year negative. This is great news for the patient long-term investor as the odds are in your favor if you stay in the game. The October intra-month correction stemmed from a handful of factors converging on the market in early October. There was anticipation of third quarter corporate earnings releases, a European economic slowdown or possible recession, EBOLA concerns, terrorist activity, Euro dollar weakness versus U.S. dollar strength, falling oil prices, the U.S. Federal Reserve ending quantitative easing and nervous investors hiding in the shadows of 2008.

The monthly numbers hid the daily thrill ride, but when the dust settled markets were little changed in October. On the relative strength of the U.S. economy, U.S. equities once again outperformed international stocks. For the month, the NASDAQ, S&P 500, and the Dow Jones Industrial Average had positive results of 3.09, 2.44 and 2.16 percent respectively. International results were mixed with the MSCI EAFE down -1.45 percent and the MSCI Emerging Markets up 1.18 percent for the month. Commodities prices fell during the month as oil declined by another $10 per barrel and gold declined on the firm U.S. dollar.

Like stock prices, interest rates had a wild ride of their own during the month, and ended October with lower U.S. Treasury rates. Five, ten and thirty year Treasury rates fell by 16, 17, and 14 basis points to yield 1.62, 2.35 and 3.07 percent respectively. During the height of the October equity market panic, the 10-year U.S. Treasury hit a monthly low yield of 1.85%. This flight to quality move was swift and rates immediately reversed course back above the two percent level. Lower interest rates across the yield curve helped produced a 0.98 percent monthly total return in the Barclays Aggregate Bond Index. All in all, bonds have been remarkably stable in 2014 and we expect this to continue into 2015.

Markets can move quickly, but remember portfolios are constructed to meet your financial goals which are long-term goals. Your investment time horizon should be a long-term one to match the duration of your goals. Results should be measured in years or multi-year time frames. The emotional struggle comes from focusing on market noise which forces the unwitting investor to measure results in days and weeks. Breakaway from the herd, become a long-term investor and begin thinking in years, not days.

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.

In August, the S&P 500 topped 2,000, the NASDAQ hit a 14-year high, the Dow Jones Industrial Average crossed 17,000 and interest rates remain low so the question everyone is asking: Where do we go from here?

The three to seven year answer is likely higher stock prices and marginally higher short term interest rates. What happens in the financial markets over the next month or the remainder of the year is a more difficult question to answer. The elusive stock market correction has yet to surface and the prediction of higher interest rates still remains a prediction. The financial markets have an uncanny ability to inflict the most pain on the largest number of investors. While the vast majority of investors are positioned for a stock market correction and/or higher interest rates, it should not be a surprise that stocks are moving defiantly higher and interest rates are grinding lower.

August was another solid total return month across many asset classes despite heightened concerns over geopolitical fires that continue to burn. Second quarter corporate earnings were strong and the economy snapped back proving the first quarter results were hindered by an exceptionally harsh winter. The consumer, the main driver of our economy, is more confident than ever and continues to spend at a steady rate. This trend, if maintained, bodes well for future stock prices.

The U.S. stock market set the pace in August. The NASDAQ Composite gained 4.99 percent, the S&P 500 added 4.00 percent and the Dow Jones Industrial Average was up 3.60 percent for the month. International stocks took a back seat to the U.S. this month. Emerging Markets led the international segment gaining 2.25 percent while the MSCI EAFE Index posted a small decline of 0.15 percent.

The fixed income market was running on both cylinders: lower interest rates and tighter credit spreads. Each of these factors equate to higher bond prices, thus bond investors enjoyed some modest capital appreciation to enhance the earned interest income. For the month, the Barclays Aggregate Bond Index was up 1.10 percent. Long term US Treasuries lead the way with an equity-like 4.06 percent monthly return. High yield, investment grade corporate bonds and municipal bonds all had monthly returns greater than one percent.

The bond market has found its happy place. Economic growth is not too hot and not too cold. Inflation is well under control and energy costs are on the decline. The Federal Reserve has telegraphed their intentions of ending the bond purchase program in 2014 and will very gradually begin moving the Fed Funds Rate higher sometime in 2015. U.S bond investors often overlook the global yield landscape. The chart below show 10-year government bond yields from some other developed countries and one can easily argue the 10-year U.S. Treasury at a 2.39 percent yield is a great relative value at these yields. Don’t be surprised if we see a 2.00 percent U.S. 10-year yield before we see a 3.00 percent yield.

We do not see current market bubbles in either the bond or stock markets. In the stock market, we remain cautious at these valuations but are still constructive over the long term. While a five to ten percent price correction is overdue, we would view it as a buying opportunity if it comes. Bond performance has been a positive surprise this year and when viewed in the global light, the U.S. bond market still looks attractive. At the end of the day bonds will be bonds. Set your return expectations accordingly. Earning the coupon with general price stability will be the likely path into 2015.

Our recommended approach for investors is to take a long term view, set your financial course and stay the course. Review Mike Binger’s August 25th Market Reflection piece posted on the Gradient Investment website. He discusses the pros and cons of long-term investing versus market timing. Market timing is difficult proposition in normal market cycles and can be exasperating when the market consistently defies consensus thinking. The cure to this emotional struggle is to become a long term investor armed with a long term financial plan. Add focus, patience, put time on your side and you are well on your way to achieving your financial goals.