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The markets moved dramatically up and down in the third quarter, ending down. The volatility and decline seem out of sync with the U.S. economy which has continued to show growth, albeit without much in the way of animal spirits. The U.S. has a historically low unemployment rate, exhibits decent growth in consumer spending and shows improved housing prices and low inflation.

Image Third Quarter Market TreeBut, investors do not like uncertainty. A combination of factors and fears of the unknown appear to be at play. It is noted that the most dangerous times for financial markets is when “stories” become broken. A whole crop of stories broke down in the third quarter from “Invincible China” to “Energy Demand Always Growing Faster than Supplies.” This, in turn, has resulted in multiple levels of uncertainty:

  • Any degree of certainty over the U.S. Presidential election is gone. The race is now wide open. Add into the mix even more dysfunction in Congress;
  • The Chinese government manufactured equity market bubble burst and the Chinese government’s response has been described as bizarre and ineffectual;
  • China devalued its currency to stimulate exports, prompting fears of a currency war and a decline in U.S. exports;
  • China’s economy continued to slow, dragging down the rest of the emerging market economies, prompting fears of slowing world-wide economic growth and slamming commodity prices;
  • All of the above has created fears of not so much an economic recession, but a corporate-growth-and-earnings-recession;
  • Finally, continuing speculation about the course of the U.S. Federal Reserve on interest rates has spooked the markets.

Bank Credit Analyst summed up causation of the financial markets’ Jekyll & Hyde behavior this quarter:

Social herding and trend following traditionally work best in an environment of uncertainty. The assumption is that if someone else is buying or selling something and you cannot make sense of the world, they must know something that you don’t and therefore you should follow their lead. As a result, the overshoots also tend to be quite violent on occasion. Current conditions in which market participants are uncertain and confused about the data provide a fertile breeding ground for this behavior. This could lead to exaggerated moves in either direction.

The S&P 500 finished the quarter with a total return of -6.4% and -5.3% for 2015. The yield on the 10 year Treasury Bond began the quarter at 2.40% and ended at 2.09%.

There is growing risk of a full-blown market correction (a decline of at least 10% in a stock, bond, commodity or index) based on an earnings recession. Currently five of ten industry sectors are experiencing negative sales growth. Four of ten are showing anemic sales growth of 0 to 1.5% sales growth and only the healthcare sector is showing an above 2% sales growth rate. Pricing power is slipping in most industries. Valuations in industries other than energy reflect much higher growth expectations.

From a technical standpoint (trading patterns), the market is also showing signs of weakness. The market has broken down through its 200 day moving average, which is usually a significant caution flag.

On average, a correction occurs every 357 days (about once per year). Our last correction was over 1,000 days ago.

On the positive side, herd-like moves often open up longer-term opportunities. Although growth is becoming extremely scarce, the valuations of those companies that demonstrate strong growth are continuing to be highly valued.

Although we were cautious coming into the quarter, the market action did not follow our consensus thinking. We will continue to add value by being selective in our investment choices, our portfolio allocations and seeking out opportunities.