After more than a year of wild market swings, the third quarter ended up being the calmest we have seen in quite a while. The S&P 500 finished up roughly 3% this quarter and had less than half the volatility than the previous nine months. Most of the quarter’s gain in the stock market essentially occurred in the first three weeks. From there, stocks traded relatively flat for the remainder of the time. That was positively boring compared to the first half of the year where stocks gained or lost as much as 14% in a comparable amount of time.
While it’s been nice not being worried about tuning into the financial news lately, the lack of volatility is also a sign that the market has probably topped out. We still contend that most of the near-term movement is to the downside in this market. That being said, we also feel that the major negative news is probably built into the prices right now.
The markets have already digested the British/EU split, stronger dollar, presidential campaign, numerous Fed meetings and a quarter point rate hike with more to come. What is holding back the market from here is a lack earnings growth. U.S. GDP is still stuck in a sluggish 2% growth mode. Barring any policy changes or any improvement in the employment picture, it’s hard to see where any meaningful earnings growth is going to come from.
Our best guess is that we’ll have to wait until after the election to gain any insight into the expected business climate. Neither candidate has been very helpful on this front as both campaigns have been focusing on populist themes that are very anti-business and anti-growth. Of course we’ll really have to see what the true agenda will look like as there’s always a disconnect between campaign speeches and the reality of governing. The thing to keep an eye on are the congressional and senate races. Any reform will have to start in the legislative branch.
While things have been relatively tame in the stock market, bonds have been a different story. Global interest rates have continued to fall as central banks around the world have flooded their economies with liquidity. Fortunately, this relentless downward march to ever lower rates was halted in the third quarter and we actually saw rates rise from the record lows at the beginning of July. The benchmark 10-year treasury yield increased roughly 30 basis points during the quarter to settle in around 1.65%. That is still an extremely low yield but a significant reversal from what felt like a freefall from earlier this summer.
As a bond investor, these persistently low rates have made it all but impossible to generate any meaningful amount of income from traditional sources. It is true that falling rates have had the effect of increasing bond prices, but that does you little good if you need the income. These lower rates have been a savior for the stock market though. Money that would otherwise be invested in bonds has instead found its way in to stocks (especially higher dividend paying stocks) as investors seek higher returns. It’s hard to say exactly how much of the stock market’s return in recent years can be attributed the lack of yield in bonds, but you can be sure it’s a big part of the equation.
Going forward, we see little change for stocks or bonds. They both seem range bound. The S&P 500 is up around 5.5% for the year (with dividends, about 6.5%). We could see another point or two this year but it’s not likely to have the big end of year run which is common in the fourth quarter.
Bonds, too, are likely to trade around current levels. The speculation is that the Fed will raise the Fed Funds rate another quarter point before year-end. There will be a lot of news surrounding a hike should it occur but in reality there’s little difference between .25% and .5%. From an economic perspective, the Fed is still in a very accommodative mode (with or without an increase) and rates are still far off from levels that would draw money out of stocks and into bonds. This is why we believe stocks and bond yields will only advance modestly for the foreseeable future.