The third quarter was a difficult one for the stock market as U.S. stocks fell by -6.4% (measured by the S&P 500 Total Return Index). The decline in equities actually began in May, so the August selloff caused the S&P 500 to fall by more than 10% from its high, which is considered to be a “correction.” It had been nearly three years since the market had last entered correction territory, which made it the fifth-longest correction-free streak on record. Other markets fared even worse than U.S. stocks. International Developed Markets stocks were down over -10%, and Emerging Markets equities fell nearly -18% during the third quarter. Commodities were also terrible as Energy prices tumbled. The one bright spot was Fixed Income, which managed to eke out a small gain of 1.2% (measured by the Barclay’s Aggregate Index).
The main catalyst for the selloff in the third quarter was China. The Shanghai Composite Index was down more than -25% over the last three months. The drop in Chinese equities was so severe that the government intervened during the summer and halted trading in some companies, as well as purchasing massive amounts of stock. The Chinese economy has been slowing, and in August the government devalued the Yuan. The official reason for the devaluation was to give market forces a bigger role in setting the exchange rate. Market participants viewed the devaluation as a way for the Chinese government to prop up the ailing industrial sector. If the government was going to such extreme measures to prop up industry then many people thought they might be in worse shape than we think.
The Federal Reserve was also in focus during the third quarter. Everyone has been waiting for that first rate hike for what seems like forever. It seemed like the consensus was that there would be a rate hike during the September meeting. The Fed, however, decided to leave rates unchanged for the time being. The issues in China were certainly part of this decision to postpone the rate increase. Normally, investors are happy with the Fed when they don’t raise rates, but that wasn’t the case this time. We had another selloff after the lack of a rate increase because people are worried that the global economy might be slowing too much to handle a rate increase. If that is the case, it will be difficult to use monetary policy to kick start the economy because we are already starting from historically low interest rates. We also think the disappointment over a lack of a rate increase is because people are simply tired of waiting for it to happen. The Fed has telegraphed this move so far in advance it is hard to believe anyone will be caught off guard by it. At this point, it seems like the Fed risks being the parent who constantly threatens punishment, but never follows through with the discipline. Eventually, the kids stop listening and chaos ensues. Looking at the big picture, a 0.25% rate increase really isn’t a big deal, and rates will still be historically low. It seems like raising rates in the near future would signal that the Fed feels the economy is strong enough to handle it and would be welcomed by most investors.
The news hasn’t been all bad though! High Relative Strength stocks continued to maintain their spread over the broad market on a year to date basis. Momentum stocks generally performed in-line with the broad market over the summer, which leaves them ahead of the benchmarks for the year. The biggest area of excess performance this year has come from avoiding the laggard stocks. Energy and Basic Materials have performed terribly this year, and avoiding those areas has been crucial. Owning the highest RS stocks has helped, but not as much as avoiding the losers. That situation isn’t common, but we do see it happen from time to time.
Heading in to the fourth quarter we are optimistic that we are near the bottom of the correction. Many of our indicators are in oversold territory where historically, we have seen significant rallies develop. We do anticipate more volatility in the near term, but we believe the environment is setting up nicely for a rally late in the year.
Information is from sources believed to be reliable, but no guarantee is made to its accuracy. This should not be considered a solicitation to buy or sell any security. Past performance should not be considered indicative of future results. Potential for profits is accompanied by possibility of loss.