Third Quarter 2016 – Market Commentary

Markets added mild gains to their first half performance in a mostly-tame third quarter. Only after Labor Day did volatility reenter the scene. It was the familiar pattern of volatility with no progress, making it extremely difficult for investors to make money. The S&P 500 had a negative September but was able to gain 3% for the quarter, leaving it up just over 6% for the year. The Dow Jones Industrial Average gained just 2% for the quarter putting it up around 5% for the year. Technology and small-cap stocks finally broke out of their lulls as the Nasdaq Composite index recovered from a disappointing first half to gain 9.6% for the quarter alone, placing it on par with the broad indexes at up 6% year-to-date. Actively managed mutual funds continue to lag the markets as the Investor’s Business Daily Mutual Fund Index ended September up just over 4% for the year. Bonds stayed put, with the Barclays Aggregate Bond Index ending the quarter up only a half percent for a year-to-date gain of 5.8%.

Markets Display Volatility and Optimism in the Third Quarter

Last quarter we touted this bull market’s resilience. The market has shown a remarkable ability to recover from setbacks and trudge on despite its age and the abundance of challenges it faces. The third quarter reaffirmed this theme and confirmed a renewed optimism on the part of investors. From July through August and the beginnings of September the market calmly reached new highs following the climactic British vote to leave the European Union. For forty-three trade days the market did not have movement of 1% or more, either up or down. While some referred to this as an “eerie” summer calm, we believe it to be a side effect of the fact that, in order to profit in this market, there is little alternative to investing in equities. Investors may have become exhausted with buying stocks in the hunt for yield but they bought nonetheless and, importantly, did not sell.

Volatility picked up a week into September amid Federal Reserve speculation, though the movement was nothing out of the ordinary. All things considered this third quarter was always going to be the proverbial calm before the storm. The two biggest uncertainties facing the market-the final two Federal Reserve meetings and the presidential election-arrive in the fourth quarter. The domestic stakes for both events are high so we can expect heightened volatility as the resilience of this bull market and the vitality of its economic foundation are again put to the test.

The Federal Reserve Postpones and Faces Dissension

For the first time since 1963 the market followed its unnaturally long flat streak with three straight days of up and down moves greater than 1%. This whiplash that jolted the market out of its slumber was caused by worries surrounding the actions of the Federal Reserve.

The Fed met twice this past quarter and at neither meeting did they decide to raise interest rates. At the September Fed meeting three Presidents dissented from the decision not to move rates, the most dissent seen at a Fed meeting since December of 2014. In the press release following the September meeting the Fed admitted the case for raising rates has “strengthened” and Chair Janet Yellen stated at her press conference that she does “expect to see” the elusive rate hike this year. Traders have placed odds of a December hike at around 60%.
The wariness of the Fed to raise rates we think is based on their fear of disturbing our fragile, slow-growth economy. Our recovery since the Recession is the weakest since World War 2. The Federal Reserve’s own projections for GDP growth going forward are incredibly weak; they don’t anticipate growth higher than 2% through 2019. No matter the stimulus, quantitative easing, rate cuts and hikes, the Federal Reserve has not found a way for monetary policy to make the economy grow.

What the Federal Reserve does not want to do is raise short term interest rates and cause a negative chain reaction that would see suffering American businesses-whose profits have fallen for six straight quarters-invest even less in themselves because of increased borrowing costs. We think that the modesty of the actual hike (25 one-hundredths of one percent) taken together with how long short term rates have been practically zero necessitate action by the Fed, if for no other reason than to have at least some ammunition with which to strike back in case of another recession. The result of the hike will likely be short-term volatility caused by emotional overreaction, while the long-term effects of the hike will probably be minimal.

The Presidential Election

The impending presidential election added to the volatility experienced through September. Hillary Clinton and Donald Trump squared off in their first debate late in the month giving voters a clearer idea as to the differences between their respective proposed administrations. Wall Street seems to prefer the known Clinton over the unknown Trump because the market does not thrive on uncertainty. So until our next President is chosen more volatility is to be expected.

Technical Analysis

For the third quarter stocks maintained their upward trend and stayed above their 100 and 200-day moving averages. Even with the added Fed-volatility arriving in September stocks remained the favored place to invest. The interesting activity of the third quarter was not the relative stability of indexes but the directional flow of invested money. Investors reallocated away from the defensive sectors and toward riskier growth stocks. For the quarter the utilities sector (utilities companies typically provide high dividend payments) dropped -4.7% while the risky technology sector soared up 13.5%. This behavior shows investors have more of an appetite for risk even though it has been shown in numerous academic studies (as published in the Journal of Financial Economics and the Financial Analysts Journal) that greater risk does not necessarily lead to greater reward.

A corollary of investor flight from safety and to risk is the rise in bond yields. Bond yields rise as prices fall. For the quarter the yield on the 10-year U.S. Treasury bond was up 9%, up to 1.6 from the all-time low reached in July of 1.3%. Both the prospect of a Fed rate hike and heightened inflation expectations played a part the past three months in causing investors to move slowly away from credit markets. This is not to say that bond markets are back to normal. Indeed continued central bank manipulations have kept yields at historical lows and even the recovery to a 1.6% yield remains far below the 2.27% yield the ten-year bond paid just at the end of last year.

Key Economic Indicators

Gross Domestic Product

The final reading for second quarter GDP came in at a weak 1.4%. Thus far 2016’s growth is averaging only 1.1%, an undeniably terrible number that is trailing even the post-recession year average of 2.1%. And this 2.1% numbers signifies the weakest American economic recovery since 1949. From 1949 through 2007 the average annual growth rate was 3.5%; since 2008 and the ensuing “recovery” growth has not once exceeded 3%. 2010’s 2.7% annual rate was the closest we have come.

Both the New York and Atlanta Federal Reserve Banks are predicting 2.2% growth for the third quarter (the first official estimate will be released October 28th). So the failure to achieve a normal, healthy rate of growth will continue to vex economists, policy-makers, and the next president into 2017. Economic growth cannot be regulated into being. Rather, growth must be nurtured, principally by governments leaving businesses and the people who operate them well enough alone.

Employment Situation

The domestic employment situation remains a bright spot for the economy. In September a total of 156,000 jobs were added, a number below expectations but good enough to indicate a still-healthy labor market. Observers were waiting for the headline number to determine if it would sway the Federal Reserve’s decision-making either way. But because the number came in lukewarm it is unlikely to change any minds at the Fed. We are essentially at maximum employment and the slowdown in job gains reflects the reality of a full market: the lower the unemployment rate drops the fewer jobs there will be up for the taking.

Consumer Sentiment

The American consumer is feeling reasonably confident about the economy, all things considered. Consumer sentiment, as measured by the University of Michigan, ticked up slightly in September and has hovered around 90 these past two years. The non-recessionary year average is 87.5 so sentiment appears to be middle of the road. The average so far this year is lower than 2015’s, reflecting anxiety about the market turbulence earlier in the year and uncertainty about the political future of the country. Nevertheless consumer spending has maintained and the American consumer will remain the most important component of our economy and its prospects for growth as we conclude the year.
Investment Strategy

When volatility arrived in September it followed a familiar, destructive pattern of whipsawing days of selling and buying (whipsawing refers to sudden steep market moves up or down). This type of market punishes investors who may vacate the market when it is suffering its worst sell-offs but who wait just a day or two too long to buy back in. And because it takes an even greater return to recover lost ground these investors who drop into the hole often find it difficult to climb out.

So, for example, had an investor in a fund that tracks the S&P 500 pulled back and missed the best three bounce-back days earlier in the year, their price return would be flat. Our portfolio management process, aided by a sophisticated computer modeling system, may help to remove this self-inflicted investment mismanagement by analyzing price movement alone. This quantitative strategy permits responsiveness and risk management by either getting defensive or attempting growth participation depending upon the analysis of current price trends.

The market, moreover, is two-faced: it is upwardly trending but at times relentlessly volatile and often to the downside. This dual behavior often requires multiple strategies that we are able, through our quantitative investment technology, to deploy on your behalf. First, to attempt to take advantage of the market melting higher but alleviate accompanying volatility we may utilize a strategic tool called Target Volatility. Target Volatility allows us to maintain market participation while simultaneously limiting the amount of volatility your investments will be exposed to. By setting a cap on tolerable volatility we try to dampen the devastating damages random market sell-offs can inflict. Second, to try to capture short-term gains that can occur randomly throughout the market we may utilize a tactical tool called Rank Models. Rank Models trade in and out of securities quickly and attempt to place portfolios in a better position to be able to make volatility work for the portfolio instead of against it. Both of these strategies may be used in addition to our standard quantitative modeling process that also is able to adapt to the recent market price disruption.

Looking Forward

Having observed the market’s resilience, investors reallocated away from the safety of defensive sectors and reentered the riskiest sectors that have the best chance for growth. This movement tells us that the consensus belief is a continuing bull market in equities and an economy that still has room to expand. Regardless of the validity of this belief, the thing we can be assured of is volatility through the fourth quarter. October and November will bounce the market around because of presidential politics and we will see similar seesawing in December because of the Federal Reserve meeting.

Given the significant uncertainties facing the market, growth will likely be held in check by the irrational volatility that always accompanies investor perceptions of the unknown. Whipsaw trading wreaks havoc on investors and makes it that much more difficult to extract gains. And based on the market behavior of late-September, this volatile trading will cause the challenging market environment to persist.

Performance Disclaimer

No investment strategy or methodology can guarantee profits or protect against losses. Investment risk includes the uncertainty and volatility of potential returns for a portfolio or an individual investment over time. Investment risk is inherent in every individual portfolio and no computer model or modeling program used or relied upon in making investment choices for a portfolio can eliminate risk. A computer modeling program may not reflect actual risk and return parameters applicable to any particular portfolio or investor. Actual investment decisions made on the basis of a computer generated model or modeling program may be materially different from expected or intended results, and any computer modeling program is subject to errors in the program and system failures at any time.

Sources
http://www.bea.gov (GDP data)
http://www.bls.gov (employment data)
http://www.cmegroup.com (rate hike futures odds)
http://www.finance.yahoo.com (indexes)
http://www.sca.isr.umich.edu (consumer sentiment)
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