Q3 2015 Client Letter
October 2015
Last quarter we wrote about the unusual lack of volatility in the equity markets and noted several indications that higher, more normal levels of volatility may lie ahead. During the first part of the year markets were surprisingly calm in the face of several potential shocks. This period of unusual calm lasted through the middle of August and then volatility returned with a vengeance.
The S&P 500 finished the third quarter down -5.29% year to date while developed international equities and emerging market equities were down -5.28% and -15.47% respectively over the same period. U.S. small cap stocks were down -7.70% and the Barclays U.S. Aggregate Bond Index was up 1.13% for the year to date.
The main driver of the increase in volatility was growing concern over slowing global economic growth, particularly in China, the world’s second largest economy behind the United States. Data points on Chinese imports, manufacturing and exports were coming in below expectations and calling into question assumptions about future global growth rates. Markets were caught by surprise when China devalued its currency on August 11th , a move intended to help reignite its economy. The following week volatility spiked by over 100%, and the S&P 500 traded lower six days in a row. By August 25th, the S&P 500 was down -12.5% from the all-time high it reached earlier this year on May 21st.
While this was certainly a sudden and dramatic shift, we should keep in mind that corrections of this magnitude have typically occurred about once a year on average over the longer term. It has been almost four years since the previous correction in the fall of 2011, so we were overdue for a pullback. Corrections are normal and can be healthy for a market, helping to shake out speculative excesses and pull prices toward an equilibrium level.
The increase in volatility and concerns about potential spillover effects were cited by the Federal Reserve as influencing their decision to delay raising short-term rates following the September FOMC meeting. Markets were prepared for a 25 basis points hike accompanied by dovish language, or no hike accompanied by hawkish language. Instead came surprisingly dovish language with no hike, and this combination increased uncertainty over future policy direction. From an investor’s perspective it is like a Tom Petty song: “The waiting is the hardest part”. From the Fed’s perspective, it is more like Hotel California: “You can check out any time you like, but you can never leave”. Markets were generally weaker after the Fed’s decision and the waiting continues.
After the Fed meeting in September, attention quickly shifted from Janet Yellen and “Will she or won’t she” to Congress and “Will they or won’t they” shut down the government in another budget impasse. Speaker Boehner’s surprise resignation cleared the way for a clean funding bill and pushed the date for the next potential shutdown to December 11th.
With the government in business at least until December, attention has now shifted to earnings season. Here the story is mixed. The strong dollar and weak oil are putting downward pressure on sales and earnings of U.S. based companies that derive a large portion of their revenues overseas. At the same time, lower gasoline prices and cheaper imports are relieving pressure on U.S. consumers. Companies that derive the bulk of their revenues domestically are expected to perform better this quarter than their more foreign biased counterparts.
It is normal that sectors will ebb and flow over market cycles. Timing the precise shifts in these movements is difficult if not impossible. Our focus remains on the longer term strategy that has served our families well over the years. Maintain a globally diversified portfolio of investments. Be vigilant about keeping costs low. Be mindful of taxes. Use active managers where they are more likely to add value. Periodically rebalance out of assets that have grown more expensive in favor of assets that have become relatively cheap. Carefully plan for cash flow requirements. Where appropriate, pursue more favorable opportunities in the less correlated and less efficient private markets.
As we push to the end of the year it is time to evaluate opportunities for tax loss harvesting and portfolio rebalancing. We look forward to discussing these items with you soon. As always, we welcome your thoughts, and appreciate the confidence you have placed in our firm. We are grateful for the opportunity to work with you and your family.
Nicholas Hoffman & Co.