Is it Summer or Fall?

People in the U.S. sometimes debate whether September is a summer or an autumn month. For some, the Labor Day holiday marks the end of summer. For those with a more scientific point of view, September 23rd is halfway between the summer and winter solstices, meaning September 23rd marks the first day of fall. In that case, they would contend that the first 22 days of September must be considered summer. Instead of getting worked up about calendars and their semantics, most will agree that hot, sunny days in September sure make it feel like a summer month. However, when it comes to the history of the U.S. stock market, September is definitely not a hot month for investors.

Over the past 50 years, September has been the single worst month for stocks, on average. This September was no exception as the S&P 500 shed more than 1% during the month. While it was a negative month for U.S. stocks, it was an even worse month for foreign stocks. Developed world and emerging market stocks sustained significantly larger losses compared to domestic stocks, and the losses weren’t limited to just the realm of stocks either. Global bond, commodity, and currency markets experienced losses as well. While most of the bond market losses were modest, some commodity and currency market losses were far more severe. As we roll into the last three months of 2014, we may ask ourselves later: were the losses we witnessed in September a warning bell, or just part of what may end up being a “healthy” pullback? Right now, it’s hard to know.

To be sure, capital markets don’t suffer currency losses just because it’s September. Several factors played a role in making this September another losing month for multiple asset classes. Geo-political tensions definitely played a part in fueling losses. The Russian-Ukraine conflict caused concerns, especially in Europe. The Islamic State has advanced at an alarming rate in Syria and Iraq. Governments and health care workers struggle to defeat the Ebola epidemic in parts of Africa, and we now have our first confirmed Ebola patient in Dallas. And the list goes on. Some market watchers attribute recent losses to their belief that the present bull run for stocks is just getting old and tired. Others investors point more specifically to stock valuations, which they claim are getting too high.

In a broad sense, there is a growing divergence between the trajectories of the U.S. economy when compared to other world markets. The U.S. economy has begun to bounce back in earnest from the financial crisis that caused the Great Recession and is growing at a faster clip than most other developed economies. Many expect U.S. gross domestic product (GDP) growth to remain at or above 3% for several years, while the Eurozone may grow at a rate of only 2%. In the realm of GDP growth rates, that’s a huge difference in output. Divergences in growth rates such as these would cause further divergences in monetary policy, in stock market returns, and in currency exchange rates.
Improving growth in the U.S. means the U.S. Federal Reserve (the Fed) will be more likely to increase short term interest rates sooner than other central banks. Higher rates attract more capital, which should strengthen the U.S. dollar versus other currencies. This would have far-reaching implications, probably propelling U.S. financial assets, including stocks, upward, all things being equal. A strong dollar also works to keep global commodity prices low, which reduces expenses for U.S. businesses and consumers, meaning more money left to spend on other things.

It may sound like a broken record, but stocks continue to look more attractive overall than other asset classes, on a relative basis, for several reasons. The same factors that have fueled this bull market for years are still in place. Accommodative monetary policy around the world continues to promote high levels of liquidity, which continues to encourage risk taking among investors. In the U.S., good fundamentals, healthy earnings expectations, and acceptable valuations also point to a good environment for stocks. U.S. companies continue to aggressively buy back shares, which provides support for the share price by reducing market supply. However, the stocks of smaller companies have greatly underperformed larger company stocks because investors fear that a rate increase by the Fed will remove some liquidity from the markets, making it harder for smaller companies to find access to cash. However, small company stocks can be among the fastest to appreciate when things turn around and the recent sell-off may mean a bottom is forming.
Even though global growth has been uneven lately and is far from robust, it appears strong enough to buoy stock prices relative to other asset classes. In fact, even after September’s losses, global stock markets remain positive for the year. We will likely see a market correction at some point – after all, it’s been over 1,000 days since we’ve seen a 10% pullback – but fears that stocks are approaching bubble territory are premature. That said, we’ve seen several 4-7% corrections over the past few years and volatility has increased a lot recently.

The U.S. economy definitely appears to be regaining traction and momentum. While U.S. gross domestic product (GDP) contracted by -2.1% in the first quarter of 2014, due mostly to weather- related issues, it rebounded sharply in the second quarter when GDP (third estimate), posted a gain of 4.6%. Forecasts show GDP should easily exceed 3.0% in the third quarter. If that growth forecast for the third quarter comes to fruition, this recent stretch of economic growth would be the strongest since 2004 to 2005, the height of the last decade’s expansion. Still, the data shows that we’re in a moderate-growth environment, as the recovery has been very uneven, with businesses doing much of the heavy lifting as the consumer sector of the market has advanced more modestly. After-tax corporate profits climbed at the fastest pace in two years in the second quarter, and businesses have stepped up spending on themselves in order to grow. Business sentiment has
ticked up in recent months as well. This good news in the business sector could usher in broader economic acceleration that would eventually filter down to workers. Consumer sentiment has improved recently as well but not by much, and spending by consumers has improved only marginally, probably because this year’s surge in job growth didn’t translate into significantly higher wages.

Jobs data has improved overall as well, but the metrics are mixed. In July, U.S. employers hired the most workers since the recession began in 2007. However, revisions to June’s payroll numbers were down and the employment report for August disappointed some. While the headline unemployment rate recently came down, declining labor force participation played a big role in making the jobs market look better than it really was. Recent housing data has also been mixed, but home prices continue to appreciate overall. Inflationary pressures remain very subdued, but should trend higher in time. For now, rising inflation is far from being an issue. U.S. exports have been restrained somewhat by a soft global economy caused by slumping growth in Europe and Asia.

Growth in many parts of the world, including Europe and Asia, is slowing. Inflation is falling in Europe, which is not a good thing. Italy and Spain are experiencing outright deflation, and Germany’s inflation rate is close to 1%. Italy is in its third recession since 2008, and France’s growth was so poor that the government was reshuffled. Regional titan Germany is also slowing. Manufacturing activity in Europe slipped in September to its lowest level this year. A further area of concern is that Russia supplies gas to the Eurozone, so a hard line stance by EU members regarding the conflict in Ukraine could mean gas shortages, high prices, and more stress on Europe’s fragile economies. China and Japan are still battling lower growth, and China’s beleaguered real estate sector could unravel as central planners feel compelled to let local governments address the problem, reticent to signal a retreat from pledged reforms.

The Federal Open Markets Committee (FOMC) policy meeting in September produced no real surprises or changes. based on their expectation of steady growth, an improving jobs picture, and an acceptable rate of inflation Fed members voted to reduce the asset purchase program by $10 billion yet again and are on track to end the program altogether in October. Fed Chair Janet Yellen struck a dovish tone in her keynote address at Jackson Hole when assessing U.S. labor markets. Overall, the FOMC shared their plan to increase the fed funds rate sometime next year, again using the phrase “considerable time” when describing how long it intends to keep rates anchored at near-zero. Even as the Fed winds down its Quantitative Easing (QE) program, the global liquidity spigot remains wide open. At the same symposium in Jackson Hole, European Central Bank (ECB) President Mario Draghi stated that the ECB would likely embark on its own QE program soon. The ECB cut interest rates further in response to slowing growth and lower inflation expectations in the Eurozone, and some areas displayed outright contraction and deflation. Japan also continues with its own brand of ultra-accommodative monetary policy known as “Abenomics.”

The U.S. bond market is down slightly in September but is still modestly positive for the year, all while experiencing very little volatility. Long-dated U.S. treasuries are down in September, but they are well off their lows for the month and are up sizably for the year. A number of factors have combined to push U.S. Treasury prices higher. Fears of economic disruption from geopolitical crises in Ukraine, Iraq and other hot spots have fueled a “flight to quality”. U.S. Treasuries have become the high-yielder among “safe-haven” sovereign destinations, which could make them a major beneficiary of the ongoing global savings glut. Going forward, U.S. Treasuries should remain supported by deflationary fears in the Eurozone, the Chinese slowdown, geopolitical risks, and relatively tight supplies. High yield bonds posted losses in September and are now down YTD as well. Global bonds were flat in September, but up around 5% YTD.

We began September with an overweight in U.S. stocks and ended the month with that overweight still in place, but that position was put in cash on October 1st, pursuant to our risk- reduction protocols. We have also eliminated exposure to international stocks for the remainder of October. We will be conducting our regular, quarterly rebalancing of client accounts for the fourth quarter in October as well. We’ll use this rebalancing period to get each position back to its target allocation. Additionally, we will be making some changes in the sub-asset class weightings and at the position level.

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