Market Commentary: 3Q 2016

One hundred days after the Brexit scare and nine months after the most recent Fed rate hike, the markets once again confounded the instincts of nervous investors and went up instead of down. Last week, Federal Reserve Chairperson Janet Yellen told the world that the U.S. economy is healthy enough to weather a rise in interest rates. Nevertheless, the Fed governors met in September and declined to serve up the first rate hike since last December. That was reassuring news to the Wall Street traders and helped to provide yet another quarter of positive gains in U.S. stocks.

Larger companies were positive but posted the lowest gains. The Russell 1000 large-cap index provided a 4.03% return over the past quarter, with a gain of 7.92% so far this year, while the widely-quoted S&P 500 index of large company stocks posted a gain and is up 7.8% for the year so far. Comparably, the Russell 2000 small-cap index gained 9.05% this quarter, posting an 11.46% gain so far this year.

Comparatively, the U.S. remains a haven of stability in a very messy global investment scene. The broad-based EAFE index of companies in developed foreign economies gained 5.80% in the third quarter but is only up 2.2% for the year. European stocks have lost 2.67% so far in 2016. In contrast, a basket of emerging markets stocks domiciled in less developed countries, as represented by the EAFE EM index, gained 9.03% for the quarter and is sitting on gains of 16.4% for the year so far.

Here are the broad index returns through the Third Quarter of 2016:

U.S. Large Cap Stocks 7.8% Emerging Market Stocks 16.4%
U.S. Small Cap Stocks 11.5% Commodities 8.9%
U.S. Real Estate 12.3% U.S. Aggregate Bonds 5.8%
Overseas Stocks 2.2% International Bonds 12.5%

What is keeping stock prices high while sentiment appears to be somewhat restrained? No one knows the answer. But a deeper look at the U.S. economy suggests that the economic picture isn’t nearly as gloomy as it is sometimes reported in the press. Economic growth for the second quarter has been revised upwards from 1.1% to 1.4% due to higher corporate spending in general and especially as a result of increasing corporate investments in research and development. America’s trade deficit shrank in August. Consumer spending, which makes up more than two-thirds of U.S. economic activity, rose a robust 4.3% for the quarter, perhaps partly due to higher take-home wages this year.

Meanwhile, if someone had told you five years ago that today’s unemployment rate would be 4.9%, you would have thought they were highly optimistic. But after the economy gained 151,000 more jobs in August, unemployment remained below 5% for the third consecutive month and the trend is downward. At the same time, average hourly earnings for American workers have risen 2.4% so far this year.

Based on their reading of the Treasury yield curve, economists at the Federal Reserve Bank of Cleveland have pegged the chances of a recession this time next year at a low 11.25%. In general, a steep yield curve has been a predictor of strong economic growth, while an inverted one, where short-term rates are higher than longer-term yields, is associated with a looming recession. They predict GDP growth of 1.5% for this election year, which is comfortably ahead of the negative numbers that would signal an economic downturn.

The U.S. returns have been so good for so long that many investors are wondering: why are we bothering with foreign stocks? A recent Forbes column suggested the answer: since 1970 foreign stocks have outperformed domestic stocks almost exactly 50% of the time, meaning the long trend of U.S. out-performance that we have become accustomed to could reverse itself at any time.

No one would dispute that the economic statistics are weak tea leaves for trying to predict the market’s next move. However the slow, steady growth we’ve experienced since 2008 is showing no visible signs of ending and it is hard to find the usual euphoria and reckless investing that normally accompanies a market top and its subsequent collapse of share prices. At the current pace, we might look back on 2016 as another pretty good year to be invested.

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