Market Commentary October 2015

Posted on Thursday, October 15, 2015

R. Kevin O'Keefe, CIMA®, AIF® | Chief Investment Officer

The third quarter of 2015 was marked by heightened volatility and a series of interventions by the Chinese government. Fixed-income market performance was mixed, with wide performance dispersion between "safe-haven" and risk assets. Stock returns were negative in U.S. dollar terms, though by varying degrees, depending on country and sector.

The long-expected spike in volatility arrived in the second half of the third quarter. Troubling economic and market data from China, combined with worries that the Federal Reserve would raise interest rates for the first time in several years, contributed to a stock market sell-off which began in mid-August. At its lowest close on August 25th, the S&P 500 Index was down 14.7% from its all-time high reached on May 21st. After the sharp drop in August, markets remained volatile, with investors often experiencing big daily swings.

Performance Chart Graphic

All three major U.S. indexes posted their largest quarterly losses in four years, while the rally in the CBOE Volatility Index (Wall Street's "fear gauge") produced the most extreme readings since the fall of 2011 when the credit rating of the United States of America was downgraded by Standard & Poor's.

Dow Change Graphic

As bad as August was for U.S. stocks, other equity markets suffered more with benchmarks in the U.K., Europe, Australia, and Japan down by around 15% during the month. The Russell Emerging Markets Index lost over 25% during the same period.

The Fed

At the September Federal Open Market Committee (FOMC) meeting, the Fed decided to keep interest rates unchanged. Previous statements from the Fed suggested that an interest rate hike would come in 2015 if the Committee saw "further improvement in the labor market" and was "reasonably confident that inflation would move back to its 2% objective in the medium term."

But worsening global economic conditions, particularly in China and other emerging markets, delayed the plan to normalize interest rates, even though economic conditions in the U.S. were probably healthy enough for the Fed to proceed with raising rates. Fed Chair, Janet Yellen, has said that the Fed still intends to raise rates before year-end.  We'll See.


From its June 12th peak through its August 26th trough, the Shanghai Composite Index was down 43%. Despite this plunge, it was down just 5.6% year-to-date through the end of the quarter. No doubt some of the market crash can be attributed to the bubble which preceded it-the index rallied more than 100% in the previous seven months.

The world's second largest economy is also struggling with monetary policy and industrial production. And, importantly, let us be mindful that what happens in China affects the entire region. Falling demand for products made in China significantly impacts other emerging market economies.

US Fundamentals

Whether stocks are considered attractive at current levels depends on one's earnings expectations.  Profits for companies in the S&P 500 Index fell 0.7% in the second quarter compared with the same period a year earlier; the first such decline since the third quarter of 2012.

Softening Graphic

The consensus expectation for the third quarter of 2015 is for another, even steeper decline, as compared to the same period last year. If this transpires, it will be the first time since 2009 that the earnings of S&P 500 companies will have fallen two quarters in a row, as compared to the previous year's results.


Despite the tough times in the stock markets, it is hard to find any evidence of a looming U.S. recession. Modest expansion through the end of 2015 is the most likely scenario. Unemployment is at its lowest level since early 2008 and consumer spending continues to strengthen. The fact that growth stocks have been outperforming value stocks supports the view that investors expect that the economy will accelerate.

On the other hand, it is hard to get excited about the upside for U.S. stocks, given the uninspiring outlook for corporate earnings. Rising labor costs and the strong dollar are real challenges. It is not difficult to foresee U.S. stocks outperforming U.S. Treasuries over the next year, especially given the expected increase in interest rates-but that isn't saying much. Corporate earnings from international developed markets are likely to be stronger, particularly in Europe and Japan.

Fossil Fuel Energy Sector: A Drag on Earnings

This chart shows how consensus forecasts for earnings per share (EPS) growth as of September 18, 2015 have changed over the past eighteen months. Japan has had numerous improving EPS forecasts, and Europe is still expected to produce double-digit growth. But in the U.S. and emerging markets, EPS forecasts have been on the decline.

Forecast Graphic

In the U.S., downgrades mainly reflect the effect of lower oil prices. The consensus expectation is for the energy sector's earnings per share to decline by nearly 60% this year. In emerging markets, the story goes beyond the energy sector; earnings per share in emerging markets is headed for a second consecutive year of decline.

Favorable Months Ahead

The three months ahead have been historically quite good for stocks. October has marked the end of twelve bear markets in the post-war period, and November, December, and January have historically been the best three-month period, on average. Although 2015 has brought frustration to investors so far, history suggests it is quite possible for stocks to finish the year with an uptrend.

Fixed Income Commentary

From SNW Asset Management

Low Inflation + Global Economic Concerns = No Rate Hike and a Stable Bond Market

Bonds had a good third quarter as interest rates fell across the maturity spectrum. Much of the performance occurred in September as global financial market volatility rose and demand for "safe" asset classes like investment grade bonds increased.

In one of the most highly anticipated Federal Reserve meetings in many years, the Federal Open Market Committee (FOMC) chose to leave their target for the Federal Funds Rate at the zero bound. The Fed is clearly concerned about two issues: low inflation and global economic uncertainty. These concerns were highlighted in Fed Chair Janet Yellen's opening statement at the post-meeting press conference.

"The outlook abroad appears to have become more uncertain of late," she said, "And heightened concerns about growth in China and other emerging market economies have led to volatility in financial markets. Developments since our July meeting, including the drop in equity prices, the further appreciation of the dollar, and a widening in risk spreads, have tightened overall financial conditions to some extent. These developments may restrain U.S. economic activities somewhat and are likely to put further downward pressure on inflation in the near term."

The Fed appears to be equally focused on the global economy, particularly China, and the risk that weaknesses abroad pose to the U.S. economy.

An entire sentence was added to the FOMC statement articulating this new factor: "Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term." For context, adding an entire sentence to the statement is rare.

Modestly improving labor market conditions aren't enough to push the Fed to tighten policy. At 5.1%, the current unemployment rate is close to the Fed's long-term target for the natural rate of unemployment, but this isn't the whole story. Investors need to watch not only what happens domestically, but how global developments could impact the U.S.

Inflation will drive monetary policy decisions, and the current low levels of inflation give the Fed ample reason to keep rates low. Rates are unlikely to break out of the range they have been stuck in during 2015. The strategy of owning bonds of varying maturities to capture yield and modest price appreciation should continue to pay off.



Ignoring the Market Noise

Among the better tips for how to tolerate volatile markets is to ignore "market noise." Media commentators are primarily focused on the here and now, and not on how to systematically build wealth and achieve financial goals over a lifetime.

Easier said than done, we know. How can investors turn down the market noise, so that they can more easily remain focused on the long term? We think it might be helpful to take an objective view of conditions.

Are corporate earnings collapsing? In some places, yes - notably in the fossil fuel energy sector. Otherwise, mostly no.

Is the market overdue for a correction?Overbought conditions build up periodically, and periodic corrections are to be expected. Up until last quarter, there had not been a 10% correction since 2011.

Is a global recession imminent? Heightened uncertainty led to the August selloff. However, overall, economic conditions are positive.

What about the risk to the banking system? The system is much stronger now than it was in 2008, thanks largely to new regulations.

Will China implode? Although market conditions in China contributed to last quarter's market selloff, and while it is possible that there will be more unpleasant surprises, the more likely scenario is that China's challenges are already reflected in stock prices.

Will the Federal Reserve start a new cycle of tightening? Maybe the Fed has kept rates low for too long. However, given the volatility of August-September, they are likely to wait a while longer before raising rates. Globally, it's the same story. Central banks everywhere are doing what they can to stimulate economic growth.

What about bonds? Although rising interest rates are generally bad for bond prices, bonds still play an important role in investors' portfolios. We do expect stocks to outperform bonds over the next several years, but bonds will still (probably) generate positive returns, and more importantly, will help dampen portfolio volatility.

We are convinced that it is easier for investors to succeed if they completely ignore financial media during periods of high volatility. Scare tactics, shrill volume, and dire predictions are your enemy.  Trying to get out of stocks when prices are high and then back in when they are low is a risky, expensive game.

The stock market is risky enough; it is foolish to try to time it. What history has taught us is this: if you are patient and focus on accumulating shares of good companies over the long term, you are likely to achieve success regardless of the stock market's ups and downs.


 Kevin O'Keefe, Managing Member and Chief Investment Officer of First Affirmative Financial Network, LLC chairs the First Affirmative Investment Committee and is responsible for due diligence and monitoring of mutual funds and separate account managers.

SNW Asset Management is a Seattle-based independent registered investment advisor providing active fixed income portfolio management in taxable and tax-exempt accounts for high net worth individuals, municipalities, corporations, credit unions, foundations, and as a sub-advisor to registered investment advisors, including First Affirmative Financial Network.

Information for this Market Commentary was obtained from third party sources which are believed to be reliable but are not guaranteed as to their accuracy or completeness. The indexes mentioned in this Commentary represent unmanaged groups of investment assets, such as common stocks or bonds. Index performance does not include the impact of cash, fees, or transactions costs. Investors cannot invest directly in the S&P 500 or the other indexes mentioned, but may purchase mutual funds or other products designed to track the performance of various indexes. Investing in bonds involves risks such as interest rate risk, credit risk and market risk, including the possible loss of principal, and income from municipal bonds may be subject to the alternative minimum tax.