The market’s recent performance is in sharp contrast to that of last year’s third quarter, which produced a 13.9% loss in the S&P 500 Index.  It’s notable that most of the same problems that spooked the market last year are still present.  U.S. economic growth is sluggish with unemployment over 8 %, most of Europe is in a recession with a number of countries facing major debt problems, and China’s growth is below expectations.  In addition, in the U.S. there is significant uncertainty relating to the upcoming presidential election and a potential “fiscal cliff” (automatic spending cuts and tax hikes) that could go into effect at year end.   However, the S&P 500 generated returns of 30.2% over the past 12 months, substantially outpacing international markets.

With its recent strong performance, the S&P 500 index ended the quarter about 8% below its all-time high which was set in October 2007 (see below).  While approaching a new peak might make some investors nervous, it is important to note that estimated 2012 earnings for S&P 500 companies are expected to exceed 2007 earnings by 23%, clearly indicating that stocks are very reasonably valued compared to five years ago.  This record level of corporate earnings also demonstrates that companies have adapted their business models so that they can deliver strong performance even when overall economic growth is modest.

The strong performance of the U.S. stock market over the past year reflects a change in perspective, since most of the same problems still exist.  At this time last year, market values had fallen significantly, reflecting concerns that a global recession was on the horizon and that measures taken by government bodies were largely ineffective.  In contrast, the market’s recent advance has been primarily attributed to optimism over actions taken by government officials to reinvigorate growth.  Mario Draghi, president of the European Central Bank (ECB), stated that the ECB would do “whatever it takes” to preserve the euro and stabilize the Eurozone.  The U.S.  Federal Reserve initiated another round of bond buying  (quantitative easing) intended to keep interest rates low, encourage economic growth, and reduce unemployment.  The Chinese government announced a $158 billion infrastructure program intended to help stimulate the domestic economy.

Lower market volatility may encourage some investors to shift funds to equities, helping to support the recent rally.  In last year’s third quarter, markets were extremely volatile with the S&P 500 Index moving an average of 1.5% higher or lower from its previous day’s closing price.  In the third quarter of 2012, the average daily move was just 0.5%, a 67% reduction in volatility from the prior year period.  In last year’s third quarter there were 19 days when S&P 500’s daily move was more that 2%, compared to just one day in this year’s third quarter.  In last year’s third quarter there were 8 days when the S&P 500 advanced or declined by more than 3%.  There has not been one day in all of 2012 with a 3% move in the index.   Since investors equate market volatility with risk, lower volatility makes equities more attractive from a risk versus reward perspective.

 The Federal Reserve’s current aggressive bond buying program should also support the stock market.   The Fed’s primary goal of buying government bonds is to keep interest rates low to reduce the cost of borrowing for corporations and individuals.  More borrowing should lead to more spending and consequently greater economic growth.  A secondary goal is to inflate asset prices.  Since yields for fixed income investments are extremely low, it is hoped that money will be shifted from fixed income to higher returning assets such as equities and real estate.  Higher asset prices produce a wealth effect – when people feel richer, they spend more.

 Interest rates remained near record low levels throughout the third quarter.  The yield on the 10-year Treasury bond ended the third quarter at 1.64%, virtually unchanged from the 1.66% yield at the end of June, and down from 1.87% at the beginning of the year.  These historically low rates reflect investors’ pursuit of “safe assets” as well as demand from the Federal Reserve’s bond buying program.  Recent auctions of Treasury Inflation-Protected Securities, or TIPS, clearly demonstrate that conservative fixed income investors are willing to accept returns that are less than the rate of inflation.  In September, the Treasury sold 10-year TIPs with a yield of negative 0.75%.  It was the fifth consecutive auction of 10-year TIPS with negative yields.

 The previous paragraph includes the words “safe assets” in quotes to highlight the point that fixed income investments, which are generally regarded as safe, could actually possess a high degree of risk.  An increase in interest rates (currently viewed as unlikely any time soon) would cause a decline in the value of fixed income securities.  And while most still consider U.S. Treasury securities a safe bet, despite the downgrade from AAA status in 2011, credit risk for U.S. government securities could increase if officials do not address the rapidly increasing U.S. debt burden.   To mitigate these risks, portfolios under management have relatively short average maturities and are diversified across various fixed income market sectors.

Please contact us if you have any questions about the markets or your accounts.

— Tom Franks & Kirk Weiss