Amid worries of a weakening global economy and renewed uncertainty regarding Federal Reserve interest-rate policy, most categories of investments recorded negative returns during the July-September period. Large-company U.S. stock indices slumped by around 7%, while small-cap benchmarks fell almost 12%. Outside the U.S., developed-market shares declined around 10%, while emerging markets, as a group, plummeted nearly 18%. Real-estate securities were a mixed bag: conventional domestic issues posted modest gains, but timber-related and non-U.S. names were off between 5% and 15%. Commodities sagged: gold fell 5%, oil dropped nearly 30%. The U.S. dollar was roughly flat on a trade-weighted basis, declining slightly against the Yen and Euro, while continuing to appreciate against the Canadian dollar and most emerging-market currencies. In a familiar flight-to-safety trade, U.S. Treasury securities rallied (the yield on the 10-year Note finished the period at 2.06%, down from 2.34% at the end of June), propelling solid gains in high-quality fixed-income investments, though most non-investment grade (high-yield) debt traded lower.

Within the U.S. stock market, relatively strong returns came from stocks in the Business Services, Consumer Staples, Technology and Utilities sectors. Weaker results came from stocks in the Basic Materials, Energy and Health Care groups. Growth-oriented stocks clearly outperformed their value counterparts.

Benchmark Performance – Equities

 Third Quarter 2015

Last Twelve Months

S&P 500 Index



Large-Cap. Core Mutual Fund Avg. (Morningstar)



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 2015

Last Twelve Months

Barclays Intermediate Gov’t/Credit Index (taxable)



Intermediate Municipal Mutual Fund Avg. (Morningstar)





After an astonishingly calm first half-year, volatility returned to global financial markets during the summer, culminating in the U.S. stock market’s first official ‘correction’ (a decline exceeding 10%) in almost four years. From its May 21st all-time high, the S&P 500 Index fell just over 12% through August 25th before rebounding modestly in September; the peak-to-trough drops in the Dow Jones Industrial Average and Russell 2000 index of small-company stocks both exceeded 14%. Measures of investor anxiety – e.g., the VIX ‘fear gauge’ and the cost of insurance against bond defaults – soared. And after a first half that saw only five daily gains or losses exceeding 1.5%, the S&P 500 Index notched 13 such moves in the third quarter (with nine coming in just 13 trading days from August 20th through September 8th). The turbulence – which by some measures was as extreme as any since the late-2008/early-2009 global financial crisis – was triggered by deteriorating economic data, collapsing stock prices and a surprise currency devaluation in China that stoked fears of an economic ‘hard landing’ there that might spill over into other emerging markets or even tip the global economy into recession.

The period’s second big story was the Federal Reserve’s mid-September decision to postpone its first (and much anticipated) interest-rate hike since mid-2006. Prior to August, most investors had become comfortable with the notion that a strengthening U.S. economy would soon allow the nation’s central bank to begin engineering a gradual rise in the short-term interest rates it has held near zero since the end of 2008. A September rate hike would have signaled Fed confidence that the U.S. economy (and the global financial system) were sufficiently healed from their 2007-2009 trauma that both could withstand higher rates. That the Fed instead demurred sent the opposite message: investors should be afraid of renewed global economic weakness and market turmoil. Although Fed officials including Chair Janet Yellen signaled after the September meeting that they still expected to raise rates before yearend, the seeds of doubt had already germinated.

Domestic economic news reported during the quarter was generally upbeat. Overall output (GDP) in the April-June period expanded at a robust 3.9% rate, up from just +0.6% in the prior three months. Among more timely data, strength was apparent in the residential real-estate market and auto/truck sales, while the labor market sent mixed signals: job openings and new claims for unemployment insurance indicated a robust employment market, while a noticeable down-shift in monthly payroll gains suggested relative softness. Auto-makers aside, the manufacturing sector, which is most directly exposed to commodity-price weakness and dollar strength, was relatively sluggish, but the much larger services sector continued to grow near the fastest pace since before the recession. Lower gasoline prices and the strong dollar kept inflation well below the Fed’s preferred rate of 2%, where it has been tethered for more than three years.

Overseas developments were decidedly less benign. While the Euro zone continued to eke out modest growth of around 1.5% (and the apparent resolution of the Greek crisis was a relief), Japanese output declined at a 1.2% rate in the second quarter. Resource-dependent economies like Australia and Canada struggled; the latter entered recession after recording its second-straight quarter of contraction. Chinese statistics, particularly those emanating from the manufacturing sector, seemed to indicate that growth had slipped – perhaps substantially – below the official 7% target, though measures of real-estate prices and service-sector output were less grim. In a surprise move whose exact motivation remains controversial, the People’s Bank of China abruptly allowed the RMB to depreciate by around 3% against the U.S. dollar – the first such move in over a decade. Chinese stock markets continued to gyrate wildly. Elsewhere, the Brazilian economy was mired in deepening recession and hamstrung by political dysfunction, prompting Standard & Poor’s to revoke the nation’s investment-grade bond rating. The Russian economy continued to be battered by the triple-whammy of low energy prices, a decimated currency and foreign trade and financial sanctions. India remained a relative bright spot with growth coming in at +7.0% in the latest quarter. Oarsman Capital, Inc. 3

Earnings reported by large American companies during the period (mostly covering the April-June quarter) came in nearly 11% below the year-earlier figure; the trailing-twelve-month comparison was a less dire -3%. Wall Street analysts expect a 3% decline for the third quarter (to be reported over the next several weeks), before an upturn in the year’s final three months. That pattern would bring full-year 2015 earnings to a level 2% below last year’s tally.

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 (annual yield divided by four)

2) +/- Change in expected earnings* (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 explain the -6.4% S&P 500 total return?

Third Quarter (July–September) 2015

Dividend income



+ Change in expected earnings


+ Change in valuation


= Total Return




The key question confronting investors is whether the recent market dislocation is anomalous noise or, rather, anticipates a meaningful deterioration in the prospects for financial-asset returns. The strong performance of most investment categories following the financial crisis and ensuing recession has been driven by a potent combination of exceptionally supportive liquidity conditions (anchored by exceedingly accommodative global monetary policies) and robust corporate profitability. Though many overseas central banks remain committed to accommodation, the U.S. Federal Reserve (as well as the Bank of England) have spent much of the past two years preparing market participants for a gradual return to a more normal monetary regime (i.e., higher interest rates), thus undermining one of the bull market’s pillars of support. After an initial spasm of volatility (the mid-2013 ‘taper tantrum’), however, market gains resumed, propelled by continued solid earnings growth. Investors, it seems, were sanguine that as long as profit growth persisted, the transition to a less supportive liquidity environment could be reasonably smooth.

Over the past year, however, the collapse in the prices of oil and (to a lesser extent) other commodities, along with the near-20% trade-weighted appreciation of the dollar, have had a massive negative impact on corporate profits. As recently as January, year-over-year growth of reported S&P 500 earnings was +12%. At that time, Wall Street analysts, failing to anticipate the magnitude of the commodity collapse/dollar surge, were calling for a similar gain in 2015. By April/May, however, reported profit growth had turned negative; as noted above, the second quarter came in at minus 11%. We expect that by the time the books are closed on 2015, full-year earnings will be around 5% below the 2014 figure – a very unusual outcome outside of a recession.

Given the continued likelihood of a looming – even if delayed – withdrawal of monetary support, the key to stock-market performance is likely to be whether earnings growth resumes. We see scant evidence the U.S. economy will slow meaningfully from its recent 2% to 3% growth rate, though the surprisingly weak September jobs report introduced an element of downside risk to our assessment. Overseas, we expect modest, but slightly improving, growth in most major developed markets, though the emerging-market universe is a veritable sea of weakness and/or uncertainty (see below for additional discussion of China). Putting all this together, the most recent forecast from the International Monetary Fund projects global growth this year to come in slightly below the fairly anemic +3.4% gain recorded in 2014, before turning up modestly next year. Importantly, it seems likely the headwinds of collapsing commodity prices and a soaring dollar are largely behind us. Moreover, massive corporate cash holdings – and lower stock prices – should allow a boost in per-share earnings via increased stock buy-backs. With these facts in mind, Wall Street analysts have penciled-in a robust earnings gain of around 15% next year. Given tepid demand growth and little scope for most companies to expand profit margins, we suspect that bar may be too high. We would be pleased to see the return of mid- to high-single-digit gains, but suspect that result would disappoint many investors.

The true trajectory of the Chinese economy – and its likely impact on the rest of the world – is perhaps the biggest unknown. Skeptics have recently pegged actual growth at closer to 4% than the official 7% figure reported for the April-June quarter. Our take is that actual growth likely has not changed nearly as much as have perceptions of the competence of Chinese authorities, who are attempting to manage a daunting, decades-long transition from an investment- and export-led economy to a more sustainable model that relies increasingly on domestic consumption and services. As we analyze the giant though opaque Chinese economy, however, it is also important to keep it in perspective. First, at market exchange rates, China accounts for only about 15% of the global economy (the U.S. and Euro Zone are each greater than 20%). Moreover, direct linkages to the U.S. economy are surprisingly limited: American exports to China generate just over 1% of U.S. GDP (though that figure is greater for Japan, many other Asian nations, and the Euro zone). Likewise, the Chinese financial system is still largely isolated from the rest of the world. Finally, because China’s economy has roughly doubled in size over the past eight years, growth of 5-6% would add as much to global output in 2016 as 10% did in 2007. While our own views regarding China are evolving in the direction of skepticism, we acknowledge that the authorities in Beijing (unlike those in Washington, Tokyo and most European capitals) retain ample ammunition to stimulate their economy via lower interest rates and bank-reserve requirements, increased government spending, or even further devaluation of their currency. Still, the weakening data and threat of spill-over to other emerging markets clearly skew global economic risk to the downside, and we will continue to scrutinize developments in the Middle Kingdom with keen interest.

Despite recent market turbulence and growing uncertainty regarding the outlook for economic and profit growth, we view the underlying picture as fairly straightforward: market gains since roughly the end of 2013 were predicated on earnings growth that failed to materialize. Meanwhile, the liquidity tailwind is expected to reverse in coming months, which – all else equal – would be expected to weigh on stock prices. Not surprising, then, that stocks are off their all-time highs. In recent letters we have noted that aggregate stock-market valuation was becoming stretched. As noted in our ‘What’s Changed?’ box above, the recent correction has gone some ways to alleviating this issue. Moreover, strong relative performance by some of most valuable companies (e.g., Amazon, Facebook, Google) means the published decline in capitalization-weighted indices like the S&P 500 understates the decline of the average stock. Indeed, numerous high-quality stocks are 20%, 30% or even further off their highs, with many now sporting dividend yields in the 3.5% to 4% range. Compared to a 10-year Treasury yield of 2%, we sense value. While doubts abound, markets are likely to remain choppy. But it is often in the midst of such volatility that investments with superior prospective returns are made.

Please let us know if you have questions regarding our management of your investments.

Alan Purintun, CFA                                  Robert W. Phelps, CFA
Principal & Portfolio Manager              Principal & Portfolio Manager

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