The steady, upward march in stocks that we experienced during the second quarter met some headwinds in the third quarter. Although the S&P 500 index of large cap stocks was able to eke out a small 1.1% total return for the three months, market breadth was narrow and most asset classes like small caps, mid caps, REITs and commodities turned in losses. Concerns surrounding slowing global growth rates and geopolitical tensions weighed on investor sentiment. Yet, despite the rockiness of the quarter, on a year-to-date basis the S&P 500 returned a solid 8.3% through the end of September. International stocks, both developed countries as measured by the MSCI EAFE and emerging markets represented by the MSCI EM index, struggled during the quarter like so many other sectors of the market. They fell 5.9% and 3.5%, respectively. When we look at the world as a whole, stocks as measured by the MSCI ACWI were off -2.3% for the quarter but still returned a positive 3.7% through the first three quarters of the year.
Bonds were relatively flat during the quarter with the Barclay’s Aggregate up a mere 0.2% in the face of questions regarding when the Fed would begin to raise interest rates. But bonds have been a surprisingly strong performer for the year with the Barclay’s Aggregate having returned 4.1% on a year-to-date basis, defying the expectations of nearly all strategists. At the outset of the year, the broad consensus held that the bellwether 10-year Treasury yield would rise from its 3% level. But, by the end of third quarter it had actually fallen to 2.5% despite the Fed having widely telegraphed the end of Quantitative Easing (QE).
A notable characteristic of 3Q14 was the continuation of the outperformance of passive investing over active managers. This is a trend that has been exacerbated by the Fed’s Quantitative Easing which has led investors to feel comfortable taking on higher levels of risk. We’ve been in an unusually long cycle of low quality companies, as measured by unprofitability and high levels of debt, leading the market. These low quality companies make up a much larger percentage of the various equity indices/benchmarks than actively managed portfolios. Active managers tend to focus on fundamentals and strive to invest in high quality companies with strong growth prospects. This focus guides them away from debt-laden and unprofitable companies. Yet from a performance standpoint, over the past two+ years, we’ve seen low quality companies turn in substantially higher performance across an array of asset classes. We reached the end of QE just last week. As we move toward the “tipping point” when the Fed actually raises short-term interest rates, we would expect to see fundamentals matter more and for active managers to be rewarded for the quality of their portfolios.
In our second quarter Investment Update, we wrote at length about the lack of volatility that we had been seeing in the markets and that investor complacency was a concern to us. It’s interesting to look back at charts of the Volatility Index (VIX) and see that, in the short run, July marked the absolute bottom of market volatility. The mid-September through mid-October sell-off in stocks generated a spike in volatility, indicating to us that there was true fear in the marketplace. But we want to point out that pullbacks such as our recent 7.4% decline in the S&P 500 (9.5% if we measure from intraday prices rather than closing prices) are regular occurrences and part of a normal functioning market. We have experienced five significant market declines since the beginning of this bull market in 2009, and in each case the durability of the global recovery was called into question. On each occasion, including the most recent, the concerns were either exaggerated or unfounded.
We think that the U.S. economic recovery is intact and that we are only mid-cycle in this recovery, not at the end. Although economic growth continues to be somewhat tepid, the U.S. labor market is strong with job openings at their highest level since 2001 and unemployment continues to fall. Corporate profits for the third quarter have come in strong. Demand for commercial and industrial loans is rising and managements are guiding higher on planned capital expenditures. And with gas prices falling, consumers have added disposable income in their pockets, which could drive spending higher, particularly during the important holiday season.
When our Investment Policy Committee convened at a regularly scheduled meeting on the afternoon of October 15th, we had no idea that the market had just made the bottom of our recent sell-off. We were prepared for further downside. However, during our discussions, we formed a consensus agreeing that not that much had changed in the global economic landscape. Of course, we need to keep our eyes open for any further deterioration in growth rates in major world economies like the Eurozone, China and Japan or shocks from outside forces like Ebola or geopolitical events. The world is far from tranquil. However, like the four significant sell-offs that had come before during this extended bull market, we were experiencing a downturn in stocks that appeared to be based on overstated concerns of economic deterioration. Thus, we concluded that this was the correction that we had been anticipating and therefore a buying opportunity. We were seeing valuations move back to a more compelling level which is the ultimate basis for First Western’s market allocations.
We truly appreciate the trust and confidence that you place in First Western. Please reach out to us if you have any questions.
Debbie Silversmith, CFA Warren Olsen
November 4, 2014