Market Update

QUARTERLY MARKET UPDATE as of October 2015

Equity markets were hit hard in the third quarter. US markets lost almost 7% as measured by the S & P 500 while small capitalization and international stocks fared even worse, falling more than 10%. All sectors except Utilities were down with declines in the Energy and Materials sectors approaching -20%. As a safe haven and with expectations of slower growth, investors increased their Treasury bond purchases causing longer term interest rates to fall 1⁄4 of a percent.

After three previous strong years a market correction is not unusual. The quickness and severity of this decline have similarities to the third quarter in 2011, and on a monthly basis, to the month of October in 2014. In both cases the market decline was followed by an equally strong rebound. That may not be the case this time, but while it is a challenge to predict a correction in time and duration we rely on the underlying economic fundamentals to discern between cyclical and secular trends.

There are various concerns weighing on the market. First, there are headlines of slowing global growth, especially the outlook in China. A lack of inflation is also viewed as a concern that our own economy may be slowing down. Healthy markets exhibit strong earnings growth, and that is currently absent. Corporate profits contracted in the second quarter for the first time in three years and expectations are for another decline in the third quarter. There is also the uncertainty over the timing of the Federal Reserve Board’s ever pending interest rate increase.

While Chinese growth is slowing, it is still 2 1⁄2 times greater than the growth in the US. Recent and forthcoming monetary and fiscal stimuli within China may abate their slowdown, and evidence from retail sales reports of a pickup in consumer spending looks promising. However, this summer’s devaluation of the Yuan may be a harbinger of more serious growth issues in China. This move also triggered other countries to devalue their currencies. A continuation of this trend could destabilize global markets through expectations of a trade war. It may stimulate Chinese exports, but a stronger dollar slows US growth.

Inflation is benign. The latest report for core personal consumption expenditures, the Fed’s preferred inflationary index, was up a scant 0.1%. This past year’s decline in energy prices and other commodities has fueled concerns that this trend will continue. Deflation occurs when the change in the price index turns negative. This can lead to lower demand, and in turn a production slow down and increased unemployment.

Some of the recent economic reports should alleviate these concerns. Consumer spending increased 0.4% in August and was revised upward for July. Personal income also increased a healthy amount. September auto sales surged, showing the largest increase in ten years. Perhaps the decline in energy prices may have had a delayed stimulus effect that is just starting to show up. As well, the August stock market decline did not hurt consumer confidence which came in very strong and exceeded expectations. Meanwhile, construction spending rose to its highest level since 2008. The trend in unemployment is also positive, improving substantially over the last five years.

The reports on housing have been mixed. Existing home sales along with prices have been weaker than expected. But new home sales, a more important economic indicator, were very strong. Also, mortgage rates have come down in the last month following the fall in bond yields. This typically has a positive impact on future housing reports.

Overall corporate earnings growth has been weak and should be evident this month when the third quarter reports come out. This weakness has been heavily driven by the energy and manufacturing sectors. Excluding energy companies, both earnings and revenues would have been positive. Peeling back another layer, if companies with a majority of sales outside the US are excluded, the earnings growth rate is over 8%. Next year consensus earnings for all companies in the S & P 500 are expected to increase 9% year over year.

Volatility has increased and may remain high for the near term. Uncertainty over the Fed raising interest rates, along with the possibility of more currency devaluations in Asia will weigh on the market. But taking in all of the economic reports leads us to a more positive outlook. With the recent market correction we see many opportunities to own solid companies at clearance prices. Valuations in the market are more reasonable. The S & P 500’s one year forward P/E is at 16, not far above the historical average of 14.8, and reasonable when taking into account today’s low interest rate environment. In the global markets, the US still represents an island of stability. We see investors continuing to stay the course with a fairly static asset allocation. US equities will remain favored over bonds in the fourth quarter and significant rotation to international investments is unlikely.