Third Quarter Review

The third quarter was a trying one for U.S. and global investors.

The MSCI All Country World Index is down 6.9%. Year to date the Bloomberg Commodity Index is down 16%. Bank of America’s global debt index gained 1%, less than the 2.5% increase in world consumer prices. The Bank of America, Merrill Lynch Global Corporate and High Yield Index is set for its first decline since 2008.

Other benchmarks did not fare so well either in these past 3 months:

Euro Stoxx 600 -8.4%

Nikkei -14%

Shanghai Composite -28%

Brazilian Bovespa -15%

Russell 2000 -12.7%

DJIA -8%

NASDAQ Composite -7.9%

S&P 500 -7.4%

Investment Grade Credit Spreads +23 bps

High Yield Credit Spreads +147 bops

Copper & Gold Worst Quarter Since 2011

Oil -24%

The Dow Jones Industrial Average has now fallen three quarters in a row, first time since Lehman‘s demise in 2008 and only the second time since 1978.

After three years of rising share prices and unprecedented monetary easing, markets are now sinking as emerging economies weaken and corporate profits slump.

World oil prices have dropped more than 60% from their 2014 peak on increased supplies. China’s economy slowed from 10% to 6% growth, affecting demand for global commodities. Europe and Japan are chugging along at a very slow pace of recovery.

Investors are clearly fearful about a global recession. The U.S. is on the verge of raising the federal funds rate, Janet Yellen has indicated this will happen before year end. Fears of a tightening cycle, after 7 years of easy money, have taken their toll even as rates have yet to be hiked.

Great investors like Carl Ichan and Bill Gross have opined that this elongated period of ultra - low rates has led to the misallocation of capital by countries, businesses, and individuals.

The market as measured by the S&P 500 index is down 6.7% YTD. After May’s 2132.82 SPX peak, yesterday’s close of 1920.03, leaves the benchmark down 9.98%,following a peak to trough decline of 12.47% at the flash crash low on August 24, 2015.

Is this the long awaited “correction” that refreshes every bull market or a new bear market of unknown depth?

This determination can be made by looking at several important elements including; earnings, interest rates, and psychology.

According to Fact –Set, Q3 2015, SPX earnings will decline 4.5 %, its first back to back quarterly earnings decline since 2009. The 12 month forward earnings guidance yields a P/E of 15.2 higher than the 5 and 10 year average. However, 2015 consensus estimates are $118.74 for 2015 and $130.80 for 2016.

Industrials -5.8%, Materials -13.1% and Energy -64.4 % account for the largest earrings decreases for the Index over the past quarter. Telecom services are expected to report the highest growth rate of +17.6 % with Consumer Discretionary in second place +10.3 %.

In this bifurcated environment, individual stock and manager selection has begun to trump index ownership.

We expect continued market turbulence in October. Fund flows have been negative in high yield bonds, MLP’s and interest sensitive areas. All income oriented investments have suffered greatly this year with the exception of high quality corporate bonds and sovereign debt. At 2.03% U.S. 10 treasuries do not offer much in the way of yield or safety. Two year notes yield 0.64 %

Investors Intelligence shows 24.7% Bulls, a 5 year low with Bears at 35.1% some 9% points below its 5 year high, but well off the 13.3% 5 year low.

We see no U.S. recession on the horizon and the odds favor a market rebound as long as the yield curve stays positive. On the other hand, technical indicators are mostly negative and long term trend lines are breaking.

Whether or not the Federal Reserve raises interest rates this year is less important than whether the global economy grows the expected +3 %. The U.S. consumer is in good shape, with tail winds from lower energy prices and a falling 5.1% unemployment rate. GDP in the U.S. rose 3.9 % in 2 Q versus 0.6 % in Q1.

October ends the worst six month period for the U.S. stock market but has seen crashes in 1929 and 1987. We have witnessed other October drops in 1978, 1979, 1989, 1997 and 2008. . October is, however, often a” bear killer” and has turned the tide in 12 post WWII bear markets.

No one knows for sure what the next few months or years will bring. With investor’s memories of two 50% drops this millennium, fear seems to have over taken greed. This is often the best environment for stocks to resume their climb over the ever present wall of worry.

The earnings yield on S&P 500 stocks is currently 6.18 % still far better than all but the most risky fixed income investments.

Doug Coppola

John Coppola

Oct 1, 2015

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