Market Commentary - October 2016

Posted on Monday, October 17, 2016

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Stocks Finish Third Quarter on a High Note

By Kevin O'Keefe, CIMA, AIF | Chief Investment Officer

The stock market spent most of the summer moving sideways in a tight trading range. By early July, the S&P 500 Index reached its first record high in more than a year. It then took the next two months off, trading without a single daily move of 1% or more - until early September, when investors sold stocks and bonds amid worries that central banks might retreat from their easy-money policies sooner than expected.

But the Federal Reserve did not make a move to raise interest rates, and the Bank of Japan revamped its monetary policy in another effort to stimulate economic growth, which helped the stock and bond markets finish the third quarter strong.

The S&P 500 ended the quarter up almost 4%, with a gain of 7.8% year-to-date. International equity markets outperformed domestic markets. Developed markets finished up 6.4% and emerging markets finished with a gain of 9%. Bonds also finished in the black, with the Barclays US Aggregate delivering a modest 0.5% gain.

A Bullish Sign: Financial, Tech Stocks Lead the Way

MC- Tech SurgeThe search for yield since the financial crisis has driven a great deal of money out of bonds and into stocks helping to ratchet valuations up. Utilities and telecom stocks have been unusually popular over the past year, but recently, investors have begun moving out of utilities and telecommunications stocks, which lost 6.7% and 6.6% respectively in the third quarter.

Third quarter gains in financial shares as well as a rally in tech stocks may be an encouraging sign for the durability of the bull market.

Tech stocks dramatically outperformed low volatility groups over the summer. This rotation into sectors that rely more on growth suggests that the outlook for the U.S. economy is improving; investors have been gaining more confidence despite anemic corporate earnings.

Today's tech sector is a far cry from what it was in the dot-com bubble era of the late 1990s where the high-flyers weren't even profitable, let alone paying sizable dividends. Three of the top four gainers in the Dow Jones Industrial Average last quarter are tech stocks paying relatively high dividends: Apple, Intel, and Microsoft. Today there are many high-quality, dividend-paying tech stocks.

The tech sector led the S&P 500 with a 12% gain over the past quarter propelling the tech-heavy Nasdaq Composite Index to a 10% quarterly gain. Apple's share price rose 18% in the quarter. After the release of the new iPhone in September, Apple's stock had its best week in five years.

Small-Cap, International

Small-cap stocks have had mediocre performance for a while, but they kicked into high gear last quarter. The Russell 2000 Index gained 9%, leaving the S&P 500 eating its dust. The appetite for higher volatility investments has been increasing globally. As mentioned, Emerging markets had a great quarter. For the past few years, international markets have underperformed the U.S. market, but last quarter was a different story. New leadership in the global financial markets is considered positive for a healthy bull market

Headwinds

We expect stock prices to grind their way higher because there are few attractive alternatives. Insured deposits yield almost nothing, bonds yields remain low, and negative interest rates on sovereign debt are the norm in many other parts of the world.

However, despite these positive implications, sluggish earnings present challenges. Third-quarter earnings for S&P 500 companies are expected to fall about 2% from a year ago, according to analysts polled by FactSet. That would be the sixth consecutive quarter of falling earnings. Uninspiring economic data released recently on manufacturing, the service sector, and home sales also suggest that economic growth may be slowing and that an earnings recovery may be farther away than previously thought.

A recent burst of volatility arose from worries that central banks might not be as accommodating for as long as previously expected. There is no clear consensus on whether the Federal Reserve will raise interest rates by year-end. 

Financial Stocks in Focus

U.S. stocks were helped by the banking sector. Financial firms had been underperforming for much of 2016, but have started to recover in recent months. Investors moved away from less volatile sectors as confidence in the economy has improved.

But there are possible rough patches ahead, including uncertainty over when the Federal Reserve will raise interest rates, concerns about Deutsche Bank's too-small capital cushion, worries about the fallout from the Wells Fargo sales tactics scandal, and continuing sluggish earnings..

Late last month, the Justice Department proposed that Deutsche Bank pay $14 billion to reach a settlement related to its dealings in mortgage securities that led up to and contributed to the 2008 financial crisis.

This serves as a reminder that the financial crisis, although it happened almost a decade ago, still haunts the banking sector.

The size of the potential fine triggered concerns that Deutsche Bank might need to raise additional capital; however, the actual settlement may be much smaller.

Meanwhile, new regulations and more stringent capital requirements have rendered banks more resilient since the crisis.

Certain banks may need to raise more capital, but there does not appear to be a systemic global problem.

The Allure of Past Performance

In the physical sciences, outcomes are governed by laws of nature. Predictability is a hallmark of the scientific method. The social sciences, on the other hand, are subject to larger degrees of error.

For example, predicting the economy's rate of growth is a challenge compared to predicting the trajectory of a moving object in space. Investment forecasting is difficult because of the nearly infinite number of variables, most of which are human behaviors (social sciences). So, in the face of such a daunting challenge, how do investors make good decisions?

Asset flows into and out of mutual funds show a strong correlation between mutual fund ratings and fund flows: mutual funds with high ratings attract money, while those with low ratings experience smaller inflows or even outflows.

We can infer that most investors expect mutual funds with high ratings (i.e. Morningstar star ratings) to perform better than mutual funds with low ratings. This is probably because in many areas of life, positive past experiences serve as a useful shortcut to predict future similar positive experiences.

But is this shortcut useful when it comes to selecting mutual funds? Are mutual fund ratings - determined primarily by past performance - a useful predictor of future performance? The short answer is NO.

Constructing and managing portfolios is both art and science, and the analysis of past performance during various economic and market conditions is part of a robust investment process. The objective is not a portfolio that "looks good," but a portfolio that performs well in real time. This means holding certain assets that don't necessarily look good in terms of past performance.

Example: A mutual fund we use in some client portfolios has had a larger than normal allocation to emerging markets, which hurt performance in recent years. Not surprisingly the fund has had a low rating. This year, emerging markets have been on a tear, and this fund has performed better than most of its peers. If emerging markets continue to outperform, this fund will probably see its star ratings increase, which will in turn attract more money - after much of the excess return has been realized by investors who owned the fund before its ratings improved.

If this leads you to conclude that investing isn't easy, you would be correct. Investing to achieve long-term goals requires making important decisions in the face of great uncertainty. This is why we recommend that serious investors work closely with a qualified financial professional. 

Municipal Bond Market Takes a Breather

By Harris May

Barclays reported investors have been rewarded with a 4.01% total return year-to-date. However, the Barclays Municipal Bond Index, which comprises tax-exempt municipal bonds with maturities across the yield curve, showed a negative 0.30% return in the third quarter.

MC- Muni IndexBetween April and June, domestic municipal bond investors benefited from foreign investors seeking the safety of U.S. Treasuries after the unexpected Brexit vote in the UK. We also benefited from relatively low issuance, strong demand, and a somewhat sluggish economy.

But during the third quarter, the panic over Brexit faded, and demand for municipals, while strong, diminished, and new issue volume increased dramatically. Interest rates across the U.S. fixed-income market increased. The 1-year Treasury Bill yield rose 14 basis points to 0.59 and the 2-year Treasury Note yield increased 19 basis points to 0.77%.

As a result, the yield curve continued to flatten, as municipal interest rates on 1-year, 5-year, 10-year, 20-year, and 30-year paper changed by -0.46%, -11.0%, -25.0%, -0.13%, -0.25%, and -0.26% respectively. Year-to-date, the spread between 1-year and 10-year high-grade municipal yields decreased approximately 60 basis points. If the Fed tightens during the fourth quarter, investors can expect the spread between 1-year and 10-year rates will narrow even further.

The changes in the slope of the yield curve are caused by many factors, some of which are difficult to identify; however, we know of two issues that have contributed to the rise of short-term rates. First, the Securities and Exchange Commission has established rules governing money market mutual funds due to take effect in mid-October. According to MarketWatch, the new rules have frightened investors because they require shares in money market funds to float in value. Second, fears exist that the Federal Reserve will increase interest rates in response to continued strength in the job market.

During the third quarter, the 10-year municipal bond underperformed its Treasury counterpart. Consequently, the ratio of 10-year AAA GO ( General Obligation) debt to 10-year Treasury yields rose to 95.4 from 92%. This is a measure of the attractiveness of the asset class. When the ratio approaches 100%, non-traditional investors (e.g. hedge funds) buy munis and sell Treasuries.

The big surprise was that municipalities started to fund new projects. Cities in the U.S. are responsible for financing capital projects such as roads, schools, libraries, and bridges. Municipal bonds are the vehicle used to finance most of these projects.

However, Pew Research reported in April that funding for new projects in the 30 largest cities in the U.S. "had dipped to their lowest point in over 20 years." Why have they not been borrowing in a historically low interest rate environment? The answer, in part, is that it is relatively easy to issue bonds to finance a project, but not so easy to fund a project. In other words, the cost of funding the ongoing operation and maintenance of a new school or road often exceeds the cost of construction.

The Upcoming Election

Election Day is just weeks away and neither presidential candidate is very popular. One candidate is clearly a bad choice. The other may be highly qualified, but a large segment of the electorate is very worried about her ascent to the Oval Office.

MC- Donkey Vs . ElephantAnd so the outcome of the election and its aftermath is an uncertainty that will affect the financial markets, regardless of an investor's political persuasions.

We encourage our clients not to get distracted from their investment strategies by the political circus, the headlines, or the polls.

Expect some increase in market volatility around election time, and resist the narrative that any particular political outcome presages any particular development for the markets.

No one really knows exactly what economic and market environment we will find ourselves in on November 9th.

In the event that there is a weeks- or months-long rally or plunge, we will view it as an opportunity to rebalance client portfolios. 

 

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

Harris May is President and Founder of Strategic Partners Investment Advisors, Inc. and a member of the Municipal Analysts Group of New York. Strategic Partners manages separate account municipal bond portfolios for First Affirmative and other financial planning firms throughout the country.

Information 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 Market Commentary represent unmanaged groups of investment assets, such as common stocks or bonds, and are often used as proxies for various markets. 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 municipal bonds involves risks such as interest rate risk, credit risk, and market risk, including the possible loss of principal, and income may be subject to the alternative minimum tax (AMT). Mention of specific companies or securities should not be considered a recommendation to buy or sell that security. This commentary is not intended to be specific investment advice. For information on the suitability of any investment for your portfolio, please contact your investment advisor. Past performance is no guarantee of future results.