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Market Insights - October 2016

After several months of calm following the June Brexit surprise, volatility returned to the markets in early September, as investors began to focus on a contentious election, uncertain global central bank policies, and peaking bond prices. Leading indicators took a slight dip in August, raising some fear of a slowdown in economic activity, and manufacturing continued to struggle, with the ISM manufacturing Index moving below 50, usually a signal of contraction. Despite these headwinds, stock prices managed to rebound, and these gains, along with strong bond prices driven by fearful investors, worked in tandem to give balanced portfolios quite acceptable results this year.

Markets

Year-to-date, small and mid-sized companies outperformed their larger peers. The S&P small cap 600 index gained 13.8%, and the mid cap index 12.1%, while larger stocks, measured by the S&P 500, added 7.7%. Returns for the sectors we keep in focus were mixed; Real estate, measured by the Cohen and Steers Realty ETF, gained 8.4%, while the ishares Nasdaq biotechnology index lost 14.3%. Outside the U.S., developed markets managed a modest 1.7% gain year-to-date, while emerging markets shook off investor concerns at least temporarily, and added 15.4%.

Year-to-date, small and mid-sized companies outperformed their larger peers. The S&P small cap 600 index gained 13.8%, and the mid cap index 12.1%, while larger stocks, measured by the S&P 500, added 7.7%. Returns for the sectors we keep in focus were mixed; Real estate, measured by the Cohen and Steers Realty ETF, gained 8.4%, while the ishares Nasdaq biotechnology index lost 14.3%. Outside the U.S., developed markets managed a modest 1.7% gain year-to-date, while emerging markets shook off investor concerns at least temporarily, and added 15.4%.

Elections

As we speak with clients, their primary concerns are focused around the the coming election, and the effect it may have on financial markets. In almost all ways this is a defining contest; The daily newspaper generation and the twitter generation are mixing it up; regional and class differences are highlighted in a way most of us are unfamiliar with, and traditional party lines seem less clear then ever before. While disputed and contentious elections can blindside markets in the short term, we have a long history of orderly transitions of administrations that is not likely to change. 

On average, in the first year of a new presidential term, stock markets have risen by 6%. However, since 1928, the S&P 500 has lost an average of 2.8% in presidential election years (that would be 2016) that don’t include an incumbent seeking reelection. So if there’s any validity to this, we may have a bit to worry about for the remainder of the year. (The third year, though, of presidential terms has been the strongest, with returns on average of 17.5%.)  While this is an extremely important election for many reasons, we think markets will take their cue from other directions, primarily monetary policy.

The Fed

The Open Market committee of the Fed left rates unchanged at their September meeting for a sixth time. In their words, “…the case for an increase in the fed funds rate has strengthened… but decided, for the time being, to wait for further evidence of continued progress toward its objectives.”  While an increase is still expected in December, it will come after the election, and perhaps with a better sense of

the fiscal policies that will impact the economy, inflation and the markets in the long term. For now, the Fed funds target rate remains between a quarter and a half percent, as it has been since the last rate increase in December 2015. The Fed’s inflation target remains at 2% for 2018, rising from a projected rate of 1.4% for fourth quarter 2016.

There have been some warning signs, though.  While non-farm payrolls have gained a respectable 182,000 jobs monthly on average in 2016, the pace has recently slowed. Household spending (fortunately) has remained strong, but business investment continues to lag.  Leading indicators unexpectedly declined in August, although by only .2%. while the risk of recession has definitely risen, the leading indicators typically turn well in advance of the beginning of an economic downturn, and frequently predict recessions that never occur. Still, this is worrisome, especially as we are definitely in the midst of an earnings recession. 

We recall that expectations for corporate profits last quarter were quite low, and stocks rose strongly in July and August as those expectations were generally met and exceeded. However, now this data has been incorporated into projections for the rest of the year. The gap between twelve-month forward earnings projections and actual earnings is at its widest since 2009, and financial assets may react strongly as earnings begin to be reported mid-October.

Steven Weber
Registered Investment Advisor
The Bedminster Group

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