Market Commentary: 3Q 2015

The Third Quarter proved to be quite an eventful one this year. 

Increasing concern about China’s economy, accompanied by a surprise devaluation of the yuan currency, helped trigger a sharp drop in global equity markets.  In late August, the S&P 500 fell 12% from its high reached just a month earlier. It then bounced briefly from its August 25 low but dropped an additional 2.5% in September, ending the quarter down 6.5%. This marks the first negative quarterly return for the index since 2012. Developed international stocks, as measured by the Vanguard FTSE Developed Markets ETF, also dropped 12% intra-quarter, from high to low. For the quarter as a whole, they were down 9.7%. Emerging-markets stocks fared the worst, dropping 21% from their intra-quarter high in early July to their low on August 24. For the quarter, the emerging-markets stock index was down 18%. That return includes several percentage points of losses to dollar-based investors from the continued depreciation of emerging-markets currencies against the U.S. dollar.

In fixed-income markets, the core bond index gained about 1% during the U.S. stock market’s 12% intra-quarter drop. While this was strong relative outperformance versus most other (riskier) asset classes, with yields on core bonds so low (around 2.3%), their potential to generate strong absolute/positive returns over any meaningful time frame is very limited.

Here are the broad index returns through the Third Quarter of 2015:

US Large Cap Stocks -5.2% Emerging Market Stocks -15.2%
US Small Cap Stocks -7.7% Commodities -15.8%
US Real Estate -3.8% US Aggregate Bonds 1.1%
Overseas Stocks -4.9% International Bonds -4.2%                       

Economic Outlook

The recent correction was not a surprise. Given the market’s historical pattern of corrections, there was no surprise in the volatility the market exhibited in the third quarter. That is not to say that we were predicting a correction would happen or what the triggers or catalyst might be. Short-term market predictions are a fool’s errand, and history doesn’t exactly repeat. Nevertheless, knowledge of the market’s history and its cycles are useful for putting the present moment into context and thinking through different potential scenarios, risks, and investment opportunities. Otherwise, fundamentally, the economic outlook has not significantly changed from earlier this year.

The big question looming for the markets over the quarter was whether the Federal Reserve was going to raise interest rates for the first time in more than six years. Ultimately, the Fed decided to hold off on a rate hike, citing that “recent global economic and financial developments may restrain economic activity somewhat…” Fed Chair Janet Yellen pointed specifically to the recent developments in China and emerging markets as factors that gave them pause. Nevertheless, thirteen out of the 17 Fed policymakers indicated they expect to raise rates at least once this year, with six of the 13 expressing a preference for two rate hikes. The next FOMC meeting is scheduled for October 28th.

Declines create tax-loss opportunities. The reality of owning stocks is that, inevitably, the portfolio will experience bear market losses. In fact, just since 2010 the U.S. market has experienced 5%+ declines a total of 23 times!1 Owning bonds and other “safe” assets help mitigate the declines, but this interim volatility also creates opportunities to capture tax losses. By selling off some of the positions that have declined and reinvesting in similar positions, a portfolio can capture losses to reduce overall tax liability while still participating in any market recovery. Essentially, it’s making lemonade out of the markets’ lemons.

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