2016 4th Quarter Outlook

Review of 3rd Quarter

It was a great 3rd Quarter for all major sectors of the market. The S&P 500 increased by 4% for the quarter, which means it’s risen by 8% since the beginning of the year. Developed international market stocks went up b y 6% for the quarter, erasing earlier losses, and are now up 2% for the year. Emerging market stocks increased in value by 9% for the quarter and have increased by 16% for the year. Bonds went up by ½% for the quarter and 6% for the year.

U.S. Economy Below is a table showing key economic and market indicators (as of September 30)*:

The main reason that it’s been a good year for markets is that economic news has remained solid throughout the year. Unemployment is on a level that many economists (including the Fed) consider to be full employment. Inflation remains at a historically low level. And while interest rates are low, the fear that rates will rise dramatically seems to have subsided. And yet, stock market valuations, based on price-earnings levels, are near long-term historical averages.

The primary economic concern is the level of growth. Over the past year, real GDP has grown at a level of 1.3%. The consensus forecast from the Survey of Professional Forecasters is 2% per year over the next three years.

Stock Market Outlook

Because of the current state of the economy and reasonable stock market valuations, we remain optimistic on the long-term prospects of equity investing. Volatility over the past seven months has been very low, and slow and steady growth in stock prices is great for investors. The low GDP growth does put an upward bound on how high stock market returns will be, but strong economic indicators remove much of the downside risk.

Sparks that help grow the economy can seemingly come out of nowhere – sometimes we forget that when we look back at history. For example, the common current view is that the post-World War II growth happened almost immediately after the war’s end, as if the rise of consumerism was somehow pre-ordained. In actuality, there was a recession in the late 1940s, and many economists at the time felt it might lead to a second depression. The turn-around was sudden and severe – real GDP grew at a 13% rate in 1950, and the new consumer economy fueled growth for two decades. Similarly, the technology boom that created growth in the 1990s was hardly forecasted during the recession of 1991. Currently, large amounts of investment are being made in artificial intelligence, bio-technology, and other high-tech sectors. Those advances might be the stimulus for the next wave of growth.

The Election

Four years ago we presented research that presidential elections had little impact on the stock market. This year we analyzed the correlation between prediction markets (in which the odds of the election are continually updated based on “bets” of who will win) and stock returns between May and September of this year – the correlation was statistically insignificant. This doesn’t mean that the election is not important – it merely means that the markets believe that presidential actions won’t have a significant enough impact on the economy to affect stock prices.

Bond Market Our perspective on bond markets has clarified over the past few months. We don’t believe that there will be significant increases in interest rates in the near future, and investors in short-to-intermediate maturities need not be alarmed. However, we’re concerned about some sectors of the bond market – specifically investment grade corporate and high yield bonds. The level of corporate borrowing has been increasing, and yet the yields on those bonds have been declining. We’ll be adjusting our client portfolios accordingly over the next couple of months.

Summary

More than perhaps any other discipline, investing involves dealing with results that are backward looking and analysis that should be always forward looking. Hence, while we’re pleased that investors have received solid returns thus far in 2016, our focus has to be on the next few years. While we remain cautious in our enthusiasm, we believe broad diversification across equity and bond markets will achieve good results in the next few years.

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