Most categories of financial investments produced flat to slightly negative returns during the July-September period. Blue-chip U.S. stocks managed to eke out a barely-positive three-month return, while small-company stocks and most overseas equity markets declined by 5% or more. Both real-estate securities and commodity-related investments dipped noticeably; gold was off 8% while crude oil fell 13%. Bond yields were essentially unchanged (benchmark 10-year U.S. Treasuries finished at 2.51% – though yields fell sharply in early October – compared to 2.52% at June end); credit spreads widened somewhat, on average, which tempered fixed-income returns.

Within the U.S. market, the best-performing sectors were Financial Services, Health Care and Technology; lagging sectors included Capital Goods, Energy and Utilities. Growth-oriented names, on average, outperformed those in the value category.

Benchmark Perormance – Equities


Third Quarter 2014

Last Twelve Months
 S&P 500 Index



Large-Cap Core Mutual Fund Avg. (Lipper)



 Small-Cap Stocks (Russell 2000)



 Non-U.S. Stocks (Developed – MSCI EAFE)



Non-U.S. Stocks (Emerging – MSCI EM)



Benchmark Performance – Fixed Income

Third Quarter 2014

Last Twelve Months

Barclays Intermediate Gov’t/Credit Index (taxable)



Intermediate Municipal Mutual Fund Avg. (Lipper)




Returns provided by financial-market investments were mostly disappointing during the third quarter, against a backdrop of geopolitical uncertainty, sluggish global economic growth and anxiety about anticipated changes in monetary-policy.

While simmering tensions among China and its neighbors moved off the front burner, student-led pro-democracy demonstrations paralyzed Hong Kong at the end of September, ominously recalling Tiananmen Square 25 years ago. The Ukraine crisis came nearly full-circle: Ukrainian government forces gained a seemingly decisive advantage early in the period, only to be dealt a series of set-backs by reinforced Russian-backed separatists; in September, a cease-fire and ongoing negotiations seemed to herald a new, less intense phase of the conflict. Meanwhile in the Middle East, Israel went to war against Hamas (again), while U.S. policy abruptly changed course with the gathering of a coalition to take military action against the ascendant Islamic State. The rampant spread of the Ebola virus in West Africa was not reassuring. Finally, while sighs of relief accompanied the ‘No’ vote on Scottish independence (and legal set-backs to the secession movement in the Catalan-speaking region of Spain), Brazil’s presidential campaign was thrown into disarray by the plane crash that killed a prominent opposition candidate.

Following a surprisingly sharp downturn that saw aggregate output (gross domestic product; G.D.P) contract in the year’s first three months, U.S. economic news was mostly upbeat. Second-quarter (April-June) G.D.P. growth rebounded to an above-trend +4.6%. The robust expansion was boosted by additions to inventories, but also comprised solid gains in both consumer spending and fixed investment. Data from the summer showed continued momentum: car and truck sales were running at a nine-year high, consumer credit growth was well above expectations, and strong purchasing managers’ surveys were consistent with growth of around 3% in the year’s second half. Despite a dip in August, monthly job gains have averaged above 200,000 this year, lowering the unemployment rate to 5.9% (down from 7.2% a year ago and 10% at the nadir of the recession). Finally, though price gains have clearly slowed, recent reports on new home sales and homebuilders’ sentiment indicated the real-estate market may be recouping some of the strength it lost following last year’s jump in mortgage rates; this sector – a key determinant of consumer sentiment and spending – remains a concern and bears close watching.

What’s Changed?

To provide insight regarding recent stock market performance, we can deconstruct the three-month return from stocks into three components:

1) Dividend Income (for three months this is the annual yield divided by four)

2) +/- Change in Earnings per Share* (average for S&P 500 companies)

3) +/- Change in Valuation (Price/Earnings Ratio)

= Total Return

  * based on forecast earnings for next 12 months (Source: S&P Outlook)


So, what changed during the recent quarter to give us the +1.1% S&P 500 total return?

Third Quarter (July-September) 2014
Dividend Income +0.5% +1.1%
+ Change in Earnings +3.4%
+ Change in Valuation -2.8%
= Total Return +1.1%


Our read: Another healthy earnings gain (this is a quarter-over-quarter increase consistent with mid-teens annualized growth) plus flat prices equals (gradually) improving valuation.

Recently reported overseas economic developments suggested a mixed but on balance lackluster picture. Second-quarter growth ground to a near halt in the Eurozone, even dipping into negative territory in Germany, the area’s powerhouse; unsurprisingly, Russia appeared on the brink of recession. Reports for July and August reinforced a view of very sluggish growth and worryingly low inflation on the Continent. Conversely, the U.K. economy continued its recent best-in-developed-world performance, expanding by better than 3% in the April-June period. On this side of the Atlantic, Brazil recorded a particularly weak quarter at -0.9%, while Mexico notched an unremarkable +1.6%. Although Japan’s second-quarter data were slammed by April’s value-added-tax increase, recent reports (e.g., capital-spending and purchasing-managers data) were more encouraging, suggesting Abenomics remained nominally on track. Finally, Chinese growth seemed stable at +7.5% (a slight up-tick from the previous quarter), though a deflating urban real-estate bubble and rapidly slowing credit growth spurred Beijing policymakers to inject liquidity into the banking system late in the period.

Disparate economic performances led to diverging views regarding future policy changes on the part of the world’s central banks, which, in turn, roiled currency markets. With the U.S. (and U.K.) economy clearly outperforming the Eurozone (and Japan), investors became increasingly convinced that the Federal Reserve (and the Bank of England) would soon begin tightening monetary policy (i.e., raising rates), while the European Central Bank (joining the Bank of Japan) was expected to continue easing policy in the months ahead. That the U.S. dollar appreciated during the quarter versus other major currencies surprised few, though the 7% magnitude of the move caught many off guard.

Operating earnings reported by large, public U.S. companies during the quarter (generally covering the April-June period) showed a solid gain of almost 12% compared with a year ago (the trailing-twelve-month comparison was a slightly better +13%). Especially encouraging: second-quarter top-line (sales) gains were the strongest in two years. Wall Street analysts, as a group, currently expect profit growth to accelerate further, reaching +14% in 2015, although this figure is sure to be ratcheted back in coming months.


In our July letter, we described an investment environment that, though not immediately worrisome, offered a less compelling reward-to-risk trade-off compared to 12 or 18 months earlier. To recap our view: each of five drivers of prospective stock-market performance – geopolitical uncertainty, earnings growth, interest rates, valuation and investor sentiment – seemed to hold the potential to impede further market gains, even though, importantly, we could not identify a catalyst for a near-term sell-off. While these factors have changed to varying degrees and in various directions over the past three months (arguably, valuation and sentiment have improved marginally, while prospects for earnings and interest rates have deteriorated further), on balance we continue to view the near-term outlook for the U.S. stock market with a somewhat greater than normal degree of caution (though we reiterate our conviction that equities continue to hold the potential for superior long-term returns and should remain the core of most portfolios).

Reinforcing our sense of caution, a number of market indicators we track as part of our weekly investment-committee process have begun to flash amber, in contrast to the generally ‘all clear’ signals we noted in July. Deteriorating data include rising market volatility, widening credit spreads, and lagging performance by cyclical, small-company and emerging-market stocks. A recent, sharp drop in the prices of many high-yield (‘junk’) bonds was especially noteworthy. Finally, the accelerating decline of many commodity prices (even after accounting for the strength of the dollar), as well as the sudden dip in bond yields after quarter-end, were also worrisome, as they suggested a dimming view of global economic health.

Though a garden-variety ‘correction’ that pushes stock prices down 8% to 10% or even 15% is overdue (the last was more than three years ago), we see little reason to expect a more severe Bear Market. A major market decline is likely to be triggered only by the U.S. economy falling into recession or the Federal Reserve tightening monetary policy much more than investors expect. A recession is almost certainly not in the cards: there are zero signs of either overheating in the cyclical components of the economy (e.g., capital spending, residential real estate) or financial-sector imbalances that have presaged recessions over the past seven decades. And with inflation holding below the 2% threshold and full-time employment still far below its previous peak, the Fed seems unlikely to hike rates aggressively. In fact, while economists’ views on this subject vary, we are convinced by those who conclude that a worldwide combination of sluggish growth and abundant savings will keep interest rates abnormally low for the foreseeable future (that is, for years rather than months).

Even if the Bear doesn’t loom, the market’s near- to medium-term prospects might be aptly described as ‘sideways.’ As analyzed in the October issue of the Bank Credit Analyst, real (inflation-adjusted) stock prices historically have taken 20 or more years to eclipse their prior Bull Market peak; as we write, the S&P 500 (adjusted for inflation) stands only a handful of percentage points below its March 2000 level. If the historical pattern holds (by no means a sure bet), we could be entering an investment environment where capital gains are harder to come by. In that case, sustainable and preferably growing dividends would become an increasingly important driver of results. And, since elevated beginning valuation could be an important cause of ‘sideways’ prices, non-U.S. stocks, which are, on balance, substantially cheaper than their American counterparts, would be expected to provide strong relative performance. Finally, high-quality, medium-term bonds might be more attractive than widely recognized: five-year taxable and tax-exempt bonds yielding above 3% and 2%, respectively, could contribute nicely to portfolio performance in a period of sluggish growth, low inflation and correspondingly subdued stock-market returns.

We welcome comments and questions regarding our management of your investments.

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