The third quarter of 2015 was especially volatile and much of it to the down side. If you remember our 2014 year end commentary, we said that this year would be more volatile. With that being said, we certainly didn’t expect the magnitude of that volatility in the 3rd quarter. Greece and China were the big stories last quarter and we said that China, by far, was our bigger concern. Fast forward three months and Greece is off the radar (big surprise) and China is more of an issue than it was this time last quarter.
High-grade fixed income (bonds) was one of the few investments last quarter that was positive. All S&P 500 sectors were down for last quarter, as were the international developed and emerging markets. The S&P 500 was down 5.3%, the All-Country World index (ACWI) was down 6.6%, and emerging markets were down 15.2%. Our mid-cap value stocks were down 6.75%, while our mid-cap growth stocks were down 8.23%. Our sector exposure was down 10.3%, with health care and biotech contributing most of the underperformance.
Any way you slice it the 3rd quarter was bad. We do however take our victories where we can find them. We were able to buffer volatility by raising 7-15% cash in each portfolio, depending on risk tolerance. As we said last quarter, we were underweight international stocks with essentially a zero direct allocation to emerging markets, which was one of the worst performing asset classes. Fixed income, other than serving as a safe place to hide out during market periods like we just went through, continues to be an area that shows little to no value. The Barclays Aggregate index (AGG), which is essentially a measure of all the high quality bonds traded in the US, is yielding 2.24%. Combine that with an inflation rate 1.5%-1.8% (depending on which index you use) and the real return is negligible at best. Because I like easy math, if we round up to 2.25% on the bond yield and say that inflation is around 1.75%, the real yield after inflation is a mere 0.5%. At that rate, it would take you 144 years (based on the rule of 72) to double your money when taking inflation into account. I plan to live a long time, but 144 more years might be out of my expectations!
Expectations for a FED rate increase got pushed back (again) as economic numbers continue to be soft. We would argue that there is no reason for the FED to be raising rates with inflation as low as it is and the global economy as weak as it is. That probably won’t happen, because the FED wants to raise rates just to say they are off zero, and to add some arrows back to their quiver. Regardless, raising a ¼ point (25 bps) is meaningless in the grand scheme of things. We know that rates are going to go up, and the questions become when, by how much, how frequently, and what are the impacts? Ultimately, however, it is not the FED that we should be looking towards to understand areas of opportunity and concern in the market. There are other much more meaningful indicators that drive the economy and inform our search for alpha in your portfolios, such a labor participation, earnings growth, employment, fiscal policy, and more.
Finally, while our relative strength metrics have deteriorated over the last couple months, U.S. equities still appear to be the “best house in a bad neighborhood.” We are intrigued by international markets – emerging markets in particular – but we need to wait for their respective relative strengths to come up. Basically we would rather not try and catch a falling knife! We are heading into a seasonally good time of year for investing and if we can get through the spooky month of October, we may get a Santa Claus rally this year.