The July-September quarter produced a wide range of results for financial assets. Large-company U.S. stocks gained steadily, finishing the period up around 7%, while small-caps recorded lesser advances. Overseas equities were volatile and weaker, with developed markets making modest gains while emerging and frontier markets struggled for a second consecutive quarter. Real-estate- and commodity-related investments posted small losses; oil gained while gold fell. Interest rates crept higher: the 10-year Treasury yield climbed to 3.06%, compared to 2.85% at the end of June. Narrowing credit spreads allowed many bonds to record positive three-month results.

Among large-company U.S. stocks, above-average results came from the Consumer Cyclicals, Consumer Staples, Financial Services, Health Care and Technology sectors; relatively weaker groups included Energy, Utilities as well as many Basic Materials and Capital Goods names. Growth-oriented stocks again outperformed the value category.

Benchmark Performance – Equities Third Quarter 2018 Last Twelve Months S&P 500 Index +7.7% +17.9% Large-Cap. Core Mutual Fund Avg. (Morningstar) +6.9% +15.7% Small-Cap Stocks (Russell 2000) +3.6% +15.2% Non-U.S. Stocks – Developed (MSCI EAFE) +1.4% +3.3% Non-U.S. Stocks – Emerging (MSCI EM) -1.0% -0.5%

Benchmark Performance – Fixed Income Third Quarter 2018 Last Twelve Months Barclays Intermediate Gov’t/Credit Index (taxable) +0.2% -1.0% Intermediate Municipal Mutual Fund Avg. (Morningstar) -0.2% -0.1%


After a lengthy consolidation dating from late January, major U.S. stock benchmarks finally reached new bull-market highs in late August. Market ‘internals’ remained mostly healthy: the ratio of advancing to declining issues notched recurring new highs, though at the same time a somewhat unsettling number of stocks made new 52-week lows. The final few weeks hinted at a nascent market ‘rotation,’ featuring lagging returns by asset classes, market sectors and equity factors/styles that had been big winners the first eight months of the year. On the quarter, the average return of the FAANGs (Facebook, Amazon, Apple, Netflix, and Google-parent Alphabet) meaningfully trailed the S&P 500; only Amazon and Apple ranked among the benchmark’s 100 best-performing stocks, while Alphabet and Facebook were in the bottom 100 (Netflix was in the middle centile). Overseas equity returns were hampered by decelerating economic activity, currency weakness and simmering political uncertainty (in Italy, the U.K., and Brazil, for example). The first half of the period featured notable financial-market turmoil in Argentina and Turkey, which contributed to broader weakness in emerging- and frontier-market investments.

Data published during the period showed the U.S. economy accelerating after a by-now-familiar early-year lull: second-quarter GDP growth – a torrid +4.2% – exceeded heightened expectations. Monthly net job creation averaged 190,000, while the unemployment rate held below 4%; purchasing-managers surveys (PMIs) remained firmly in expansion territory; and both small-business optimism and consumer confidence were at post-recession highs. The residential real-estate market showed some signs of cooling, as prices rising at twice the pace of incomes together with higher mortgage rates dented affordability. Major overseas economies continued to expand at above-trend rates, but growth had clearly moderated since the turn of the year. Foreign-market PMIs signaled further growth ahead, though surveys of business and consumer sentiment showed some deterioration that many observers linked to concern over brewing trade tensions. Emerging-markets financial turbulence was not immediately reflected in real economic activity, which remained firm in most regions.

Bond yields vacillated for much of the period before moving higher during the last few weeks, though the rise fell just shy of surpassing the May peak. The yield curve (i.e., the yield difference between short- and longer-dated issues) steepened marginally, suggesting investors were incorporating a somewhat more optimistic economic outlook. Inflation edged up – though no higher than early in the year. At its September meeting, the U.S. Federal Reserve board raised its short-term interest rate target (to a range of 2.0% to 2.25%) and signaled its intent to do so again in December and as many as three times in 2019. A notable rise in the foreign-exchange value of the U.S. dollar that began in April petered out in mid-August; the greenback slumped around 2% in the final weeks of the quarter.

Investors in U.S. markets essentially ignored what some observers called the Trump administration’s ‘worst day yet’ (August 21st), which featured the felony conviction of the President’s former campaign chairman and the guilty plea of his long-time personal attorney: the S&P 500 rose on the 21st, fell just one point (-0.04%) on the 22nd, and went on to close at a new all-time high on the 24th. This performance made us marginally less worried about a market-cratering bombshell emerging from the Mueller investigation in coming months.

Earnings reported during the period by large, publicly traded U.S. companies once again showed tremendous gains. Second-quarter results came in almost 27% above the corresponding 2017 period. And although analyst revisions were relatively subdued, the third-quarter figure is expected to show an even greater year-over-year advance (+28%). Gains are expected to begin moderating in the year’s final three months; the early read on 2019 suggests still-healthy growth of greater than 10%.

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 +7.7% S&P 500 total return? Third Quarter (July-September) 2018 Dividend Income +0.5% +7.7% + Change in Earnings +5.3% + Change in Valuation +1.9% = Total Return +7.7%
Our read: A healthy rise in forecast earnings was exceeded by the latest jump in prices; nevertheless, valuation is slightly improved compared with the previous market high (in late January).


Economic and financial-market conditions couldn’t be much more benign – at least superficially: the American economy is healthy, corporate profits are robust, inflation is subdued, and the Fed is well on the way to successfully navigating the tricky path back to more normal (i.e., higher) interest rates. But not far below the surface lies a complicated interplay among escalating trade tensions, the relative prospects for U.S. and Chinese growth, the evolution of monetary policy, the strength (or weakness) of the dollar, and the potential for additional financial-market fireworks in emerging markets.

The recent acceleration of U.S. economic growth at a time of near-full employment has raised concerns that overheating, surging inflation and an aggressive Fed response will inevitably tip the economy into recession – possibly as early as next year. At the same time, however, global growth is clearly decelerating, and trade tensions represent an obvious downside risk. Moreover, the boost provided by last year’s tax cuts and spending increases will soon begin to fade, and the cumulative impact of tighter monetary conditions will only grow. Both reported inflation and measures of future inflation expectations – though higher than their (worryingly low) 2016-2017 nadirs – remain well behaved. The mid-year strength and more recent weakness of the dollar likely reflect investor uncertainty regarding the persistence of recent growth divergences, which have seen the U.S. clearly outperforming the rest of the world.

European Central Bank president Mario Draghi recently called escalating trade tensions ‘the major source of uncertainty’ for the Eurozone economy. Likewise, research by major European central banks and the Organization for Economic Cooperation and Development concluded the U.S. economy could bear the brunt of a full-fledged trade war. These analyses project a 2% to 3% hit to American GDP if all measures enacted and threatened to date were to remain in place over the next two years. And a trade war featuring reciprocal tariffs between the U.S. and its major trading partners, but excluding tariffs among China, the European Union and Japan, was seen as a potential boon to the Chinese economy, with Chinese suppliers gaining global market share from their American competitors. Meanwhile, many observers have concluded that China retains ample scope (as well as political will) to boost monetary and/or fiscal stimulus to offset any negative impact from trade issues.

Evidence of such concerns has been absent in the performance of the U.S. economy and financial markets. Recent data contain scant indication of building angst or early warning of a looming downturn: the yield curve has steepened; the ratio of leading to coincident economic indicators has been perched at a cycle-high; consumers and business owners remain ebullient. The Fed has proceeded methodically to remove monetary accommodation and has recently nudged investors to expect incrementally more tightening over the next year or so. Stock prices have risen nearly 10% year-to-date and hover within a percentage point of all-time highs; credit spreads have narrowed.

We are not entirely sure what to make of investors’ apparent insouciance regarding a potential threat to the globalization process that has underpinned a 30-plus-year advance in global economic growth and financial-market gains. One plausible (and hopeful) explanation is that market participants sense that many of the Trump administration’s potentially most disruptive policy initiatives (and threats) will eventually be abandoned in favor of face-saving bargains of relatively little substance (see: NAFTA renegotiation). Put another way, while it’s possible investors disagree with the central bank/think tank analyses, it’s equally plausible they don’t believe the policies being analyzed will actually come to fruition.

Though Argentina and Turkey have receded from the headlines, renewed weakness among emerging-market (EM) investments bears additional comment. To state the obvious, EM investments are frequently volatile, which can make them uncomfortable to own. But we believe they also represent an important opportunity for investors who can stomach some ups and downs. Emerging markets represents some 60% of global GDP, and an even greater share of global growth (over the past decade, EM growth has averaged around 5%, versus less than 2% for developed economies). These economies have matured markedly since the ‘bad old days’ of the 1980s and 1990s: despite occasional missteps by outliers, EM nations as a group have successful macro-economic policies that have fostered rapid growth with low and falling inflation. But as one investment-conference presenter recently quipped: which headline is sexier? ‘64 of 67 emerging-market economies growing nicely’ or ‘Argentina and Turkey on the Precipice; is Brazil next?’ While EM debt has increased, it remains lower as a percentage of GDP than among developed economies; moreover, the lion’s share of new debt is denominated in local-currencies (rather than dollars) and financed by ample domestic savings (versus fickle overseas investors). Finally, history has shown that the time to buy EM assets is during episodes of heightened financial-market volatility, which – even when caused by non-EM events – almost always induce a pronounced EM sell-off, as investors rush to ‘de-risk’ their portfolios.

On a positive note, both investor sentiment and market valuation have improved since the early-year stock-market highs. Recent surveys of individual investors have indicated a healthy level of skepticism, though investment newsletter writers were more (worryingly) bullish. According to late-September research published by investment firm Leuthold Group, popular valuation metrics had receded from sky-high to merely elevated: trailing price/earnings fell from the 87th percentile (that is, a level higher than all but 13% of historical readings) to the 72nd percentile; forward P/E eased from the 79th to 67th percentiles; and price/cash flow dipped from 94th to 82nd. Price/sales, however, remained in the 98th percentile.

Developments of the past several months reinforce the argument for broad portfolio balance in lieu of over-reliance on recently-outperforming U.S. stocks. According to the Financial Times, the relative strength of the S&P 500 versus rest-of-the-world stocks was recently greater than at any time in almost 50 years; American equities also traded at record valuation premiums to their non-U.S. counterparts. The paper also noted that investment banks JPMorgan, Morgan Stanley and Société Générale all recently recommended that clients scale back exposure to American stocks; separately, Merrill Lynch reported that institutional investors had amassed their greatest over-weight positions in U.S. stocks since 2016. Meanwhile, short-term Treasury-Bill yields (around 2.25%) recently moved above those of large-cap U.S. stocks (around 2.0%) for the first time since 2008. Cash is no longer trash! Likewise, yields on offer from high-quality, medium-term bonds (around 4% for single-A-rated 5-7-year taxables) now equal or surpass many prognosticators’ estimates of the annualized return from U.S. stocks over the next several years. In this environment, a balanced portfolio with exposure to both non-U.S. equities and investment-grade bonds has an increasing likelihood of providing superior relative performance.

As always, we encourage your comments, questions and suggestions regarding our management of your investments – and hope you are enjoying the first few weeks of Fall.

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