The third quarter felt very much like a football game where you get ahead early and then just hope you can hold on to most of your lead until the clock runs out. By mid-July, the S&P 500 had reached what ended up being its closing level for the quarter. For the quarter, the S&P 500 returned 3.8%, the Dow Industrials gained 2.8% and the small-cap Russell 2000 index earned 9.0%. For the year-to-date, the S&P 500 is now up 7.8%, the Dow Industrials 7.2% and the Russell 2000 11.5%. Year-to-date, Morningstar’s Large Cap Growth Index is up 2.1% while its Value Index is up 10.4%. In the bond market all eyes remained fixed on the Federal Reserve. Although they did not raise rates, several Fed governors suggested it was just a matter of months. A thematic “grab for yield” mentality continued the bull run in the credit market resulting in investment grade credit returning 4.3% and high yield over 5.5%. Municipals and governments were down 0.3%.
As the quarter opened, investors were still digesting the Brexit vote but the subsequent advance in the market showed those concerns were dissipating. After that early gain, the market saw limited improvement and low volatility for most of the summer. Several factors contributed to both the modest rise and then the quiet summer. The U.S. economy showed sufficient strength to ease worries about recession, but not enough strength to encourage the Fed to raise rates during the quarter. Additionally, earlier concerns regarding the emerging markets, especially China, receded amid gradual currency depreciation and improved Asian exports. Also of importance, oil prices remained at levels that were noticeably higher than where the year began.
Late in the quarter volatility returned as prospects for a rate hike increased, oil prices fluctuated, Deutsche Bank’s financial health became an issue and the world began to focus on the very contentious U.S. presidential election. Entering the fourth quarter, these issues remain at the forefront of investor concerns, and we may well see the volatility stay with us for a time.
U.S. corporate earnings continue to be lackluster. During the past three months the S&P 500’s quarterly EPS estimate dropped 2.9%. This results in the index having recorded six consecutive quarters of year-over-year earnings declines. The largest downward revisions were in the energy, real estate, materials and consumer discretionary sectors, while only the information technology sector saw earnings expectations revised upward.
A theme we hear voiced regularly is that the various central banks are nearing the limits of what they can do to try to stimulate their economies. Cash yields are at, near or below zero in many countries and investors appear to be chasing whatever yield they can find. Investors of all stripes are taking on more risk in order to meet their needed rates of return and that may create more volatility in both the fixed income and equity markets. If longer-term rates do begin to climb, stocks that are viewed as bond proxies – typically higher yielding/lower volatility plays – could be hurt. That is why we are looking at bonds with modest duration or protection against rising rates and stocks that are either growth-oriented or that can continue to grow their dividends at a healthy clip. Our asset allocation still suggests overweighting stocks in client portfolios.
Mr. Berglund is Senior Vice President at Pennsylvania Trust.
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