Stock markets enjoyed a strong rally in the quarter ending September 30, 2013.  The S&P 500 Index generated returns of 5.2% for the quarter, while the MSCI EAFE international return exceeded 10%.   Stocks benefited from continued growth in the U.S. economy, improving economic conditions in Europe and China, and reduced political tensions related to Syria and Iran.  The S&P 500 Index finished the quarter with year-to-date returns of almost 20%.  The table below shows the performance of major market sectors for various time periods.

Performance of Major Indexes for Periods Ending on September 30, 2013

The beginning of the current 5-year period coincides with the global financial meltdown in the fall of 2008.  As losses mounted, some investors decided to pull out of the market.  Many of them waited until a year or two for some stability before re-investing.  Those who remained committed to stocks enjoyed a 10% average annual return in the last 5 years (measured by the S&P 500), close to the historical average.  We think investors should have learned some lessons from this experience, as expressed by Warren Buffet, one of the most successful investors our times:

• Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.
• When others are fearful, be greedy; When others are greedy, be fearful.
• Always invest for the long term.

While the recent strong market performance is a welcomed reward for long-term investors who stayed the course over the past five years, it also raises some concern that investors are becoming  exuberant.  Stock prices have risen much faster than company earnings over the past year, making valuations relatively less attractive.  Although the economy is still expanding, it still requires a significant amount of support from the Federal Reserve through the current quantitative easing (bond buying) program. 

Stocks rallied in September when the Federal Reserve (the “Fed”) announced that it would not begin to taper its $85 billion per month quantitative easing program.  This came as a surprise, since the Fed had hinted in May that it would slow its purchases of bonds in the near future.  The Fed’s bond buying program is intended to keep interest rates low in order to stimulate the economy.  Lower interest rates make it easier and cheaper for businesses and consumers to borrow and then to use the money to buy goods and services.

The Fed buys bonds in the marketplace, rather than directly from the Treasury.  By competing with other market participants and adding to the demand for government bonds, the interest rate that the Treasury has to pay investors is very low.  At the end of September, the interest rate on the 10-year Treasury bond was just 2.62%.  The 85-year average interest rate for 10-year Treasury bonds is 5.1%, or about 2.0% higher than the average inflation rate of 3.1%.  Investors who might normally invest in Treasuries have turned to riskier assets, such as corporate bonds and stocks, to get a higher return.  So by purchasing government bonds, the Federal Reserve not only encourages borrowing and consumption by keeping interest rates low, it supports higher asset prices by creating demand for riskier assets.   It almost sounds too good to be true.  (It begs the question: Is this creating an asset bubble?)

Since its first quantitative easing program began about five years ago, the Fed’s balance sheet has expanded from less the $1 trillion in assets to over $3.7 trillion, and it is growing at roughly $85 billion each month.  While the Fed’s assets include both Treasury securities and mortgage backed securities, the holdings are significant when considering that the national debt is $17 trillion.   Eventually the Fed will buy less bonds (taper), then it will stop buying bonds, and at some point it will need to sell bonds or at the very least allow them to mature.   So far, the program has worked well, but there is significant risk in unwinding it.  Fed Chairman Ben Bernanke has taken the spaceship to Mars, now his successor will have to get it back safely.  It will be no easy task.

The Fed intends to continue to stimulate the economy until unemployment falls to 6.5%.  The unemployment rate currently stands at 7.3%.  Real GDP (the measure of all goods and services adjusted for inflation) is now 4.3% higher than it pre-recession peak in the second quarter of 2007.  However, during that same time frame the total number of people employed fell by 1.2% from 137.7 million workers to 136.1 million.   As a nation, we are now producing more goods with less workers. The U.S. is more productive due mainly to greater automation and a nimble workforce. So there is some possibility that as we continue to increase productivity it will be increasingly harder to lower the unemployment rate.  Ultimately, employment can increase if the economy grows more quickly or if the total hours worked is spread over a larger number of people.  However, that assumes that those currently unemployed have adequate abilities to do the work as more knowledge-based skills are required by employers.

Bond markets recovered somewhat in the third quarter, helped by the Federal Reserve’s decision to maintain its bond buying program.  The Barclays Aggregate Bond Index, the broadest benchmark of the U.S. bond market, generated returns of 0.6% for the third quarter.  However, this index has posted a loss of 1.9% for the year-to-date period as interest rates have risen significantly since the beginning of the year. The yield on the 10-year Treasury bond ended the quarter at 2.62%, up sharply from 1.76% at the beginning of the year.  Longer-term fixed income investments still appear to be unattractive considering that interest rates will likely increase, especially as the Fed unwinds it quantitative easing program.

With the stock market near record levels and signs of market speculation increasing, a degree of caution is warranted.  While companies are performing well in the current environment, so much of future performance is dependent on the successful actions of government leaders, policy makers, and bureaucrats. In addition to being dependent on Federal Reserve policy, markets will also be impacted by the outcome of the current budget stalemate and debt ceiling negotiations.    Looking ahead, stocks are likely to outperform other asset classes as the economy continues to improve.  However, considering the uncertainties, investors could experience greater volatility and more moderate returns in the near term.

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

— Tom Franks & Kirk Weiss