The Markets	09/30/14 Close	06/30/14 Close	3rd Qtr. Change	09/30/13 Close	12 Mo. Change	YTD Change
Dow	17,043	16,827	+1.28%	15,130	+12.64%	+2.81%
NASDAQ	4,493	4,408	+1.93%	3,771	+19.15%	+7.57%
S&P 500	1,972	1,960	+0.61%	1,682	+17.24%	+6.71%
MSCI EAFE	1,846	1,972	-6.39%	1,818	+1.54%	-3.65%
10-yr Treas. yield	2.51%	2.52%	-0.01%	2.62%	-0.11%	-0.52%
Fed funds rate	0 to.25%	0 to.25%	n/a	0 to.25%	n/a	n/a

(stock indices are before dividends; yield and rate changes are absolute changes)

The US stock market traded in a range of a few percentage points for the quarter, hitting new highs but then settling down a bit and still closing with its seventh consecutive quarterly gain. International stocks slid on concerns about slowing growth in China as well as the ongoing strife in Ukraine, which contributed to the euro weakening against the dollar. The benchmark 10-year Treasury yield fluctuated even more, hitting a low of 2.33% before closing the quarter right where it started.

The chorus for housing has become that the sector will not fully recover until millennials begin to buy houses rather than renting, and sales data is very mixed. Pending home sales were weak and sales of existing homes for August were also down as investors made up only 12% of sales compared to nearly ½ a year ago. A broader measure of home prices showed price gains slowing in 19 of 20 cities, with the average up only 5.6% from the prior year, the lowest gain in nearly two years. But new home sales, which contribute much more to the economy because of the labor and materials involved, hit a six year high in August, partly due to the month having 10 weekend days but also due to low inventories.

In addition to the weakening euro, eurozone core inflation is nearly non-existent, up only 0.8% from the prior year, so the threat of deflation will not go away. The European Central Bank cut rates even further into negative territory (meaning it costs banks 0.1% more to keep funds in reserve) to encourage lending. Eurozone GDP for the second quarter was flat and the German ten-year bond hit a record low yield.

The Fed will complete its “taper” and wind down its monthly bond purchases in October, eliminating one of the crutches for the economy and asset prices. While Fed meeting minutes show some members in favor of a “relatively prompt” interest rate hike, the official position sees no magical formula or timeline for a rate increase and acknowledges that the job market is still recovering. The bond market was briefly captivated by the resignation of “bond king” Bill Gross from PIMCO, but this has nothing to do with the fundamental value and risks of bonds, only whether investors will move their money to other funds. The SEC implemented new rules to create floating prices for institutional money market funds (not funds used by individuals) and to allow other measures to prevent a “run” if too many investors want to withdraw; the funds have two years to comply with the new floating prices.

Consumer confidence was all over the map, with one measure hitting a seven-year high in August only to fall in September based on lower expectations for the future and jobs concerns. Consumer spending for the quarter grew reasonably well and outpaced growth in incomes, with the savings rate at 5.4% and household debt up 3.6%, the most in six years. Unemployment claims continued to creep down, with the four-week average below 300,000, but August growth in nonfarm payrolls was the lowest in eight months and the June and July job growth figures were revised down. The labor participation rate dipped again, as did the long-term unemployment numbers, and unemployment overall is now 6.1%.

Bank of America agreed to a $17 billion fine for sales of toxic mortgages, and they hope that will be the last of their big legal bills (although it could grow to $23 billion with payments to other government entities). B of A has paid nearly $75 billion in 19 settlements related to the 2008 credit crisis and five other large banks have paid another $52 billion in 31 settlements. Still, no senior executives have been charged with wrongdoing, much less taken to trial or convicted.

Other broad economic measures were positive, with both service and manufacturing indexes indicating greater expansion. New manufacturing orders in particular grew in September and the latest manufacturing labor conditions hit a multi-year high. Productivity recovered after a dip earlier in the year and the year-to-date federal government deficit was down 24%. GDP growth for the second quarter was revised higher twice, ending at an increase of 4.6% with all categories improving except for consumer spending and health care spending especially strong.

Looking Forward

It’s hard to resist looking back at prior “Looking Forward” items to see how they developed. Last quarter we mentioned health care (turned out to be positive in the short term, jury still out long-term), bad weather (the economy recovered nicely, but isn’t weather always an issue?) and the end of quantitative easing (still on track for October with little effect thus far, and it will continue to be analyzed ad nauseum).

The pressing concerns right now are mostly political (geopolitical, to be more precise). The crisis in Ukraine is far from resolved and could flare up at any time. France finally acquiesced to the obvious decision to not sell two warships to Russia and more stringent sanctions may be necessary. Multiple cease fires have failed in Ukraine and attempts to agree n territorial lines have also failed. The first case of the ebola virus was diagnosed in Texas and while Nigeria and Senegal have gotten the disease under control it is far from corralled elsewhere. Protesters in Hong Kong have peacefully demanded their right to select local leaders, as previously promised by Beijing. North Korea seems to be miffed that they are no longer in the spotlight, so they sentenced three Americans to long prison sentences. Iraq and Afghanistan both have new governments which face huge challenges in uniting their countries against multiple armed adversaries. Of greatest concern, the fight against the Islamic State in Syria and Iraq has ramped up and could go on for quite a while, and the interrelationships are extremely complex. If the enemy of my enemy is my friend, how can the US fight ISIS without advantaging the Syrian regime? The list goes on, but each of these creates both uncertainty and dangers to global safety and commerce.

There will some speculation that if the Republicans take control of both the Senate and the House there could be a dramatic change in legislation. Not only is that change in control a tossup but as long as the Democrats hold the White House the political stalemate will likely continue.

Happy first birthday to the Affordable Care Act and the health insurance websites. It will be quite interesting to see how premiums change in the first renewal year. There is no question that the elimination of pre-existing conditions has helped many people get insurance, including many who retired prior to age 65 and eligibility for Medicare. The broader impacts of the ACA, as well as the cost, are yet to be seen.

Our Portfolios

Evidence in support of a long-term portfolio approach that looks beyond market corrections continues to mount. Not only have index funds continued to gain support and acceptance (see If You Must below) but advisors and newsletters that attempt to “time” markets by increasing or reducing exposure have had poor results.

What makes market timing so difficult is that more decisions are necessary (when to exit, when to re-enter, then repeat) and those decisions must be correct more often than not. It is not productive to just make one decision correctly (for example, if you were to conclude that the current market is highly valued and a correction is imminent) if the subsequent decision does not result in a net gain. You may avoid the anxiety of a big market drop, but that is usually replaced by the anxiety of when and how to make the next decision.

Mark Hulbert of the Hulbert Financial Digest reviewed the 15-year results of 81 stock-market timing advisers, and only 11 of those timers made money during the bear market from March 2000 to October 2002. Those 11 successful timers, though, have been so bad since that downturn that they have actually lost money from March 2000 until now, while a “buy and hold” strategy of US stocks shows a 4.2% annualized gain. The timers who lost money during the 2000-2002 downturn have at least made money since then, although still lagging the buy and hold approach. One theory is that if a timer makes a correct call to exit a market, he will be so concerned about risking his reputation that he becomes overly cautious in getting back into the market too early.

The best advisers over the last 15 years among the 200 monitored by Hulbert stayed invested in stocks and rarely made any market timing adjustments.

In the fixed income area, we have continued to maintain an emphasis on short- and intermediate-term bonds and will keep that position until either the Fed raises short term interest rates or the market raises intermediate and long term rates to the point that the available income is high enough to better compensate for the risk of principal loss. We have also remained cautious of the high-income investments that have attracted so many investors who are starved for income. Those vehicles will drop in price when interest rates rise and will then suffer further decline as investors who don’t understand the risks and are surprised at price drops will sell out of fear and ignorance.

If You Must

In the 40-odd years since the introduction of the first index fund available to individual investors, index funds have been steadily gaining acceptance. That swell has grown into a wave, with index funds now accounting for 28% of all fund assets compared to only 9% in 2000. Despite pundits’ all-weather advice that it’s a “stock-picker’s market”, index fund performance has beaten well over half of all similar funds over both the short and long term. And no less a legendary investor than Warren Buffett recently declared that most individuals investors would be best served by index funds (driving billions of investor dollars to Vanguard, whose fund he mentioned).

Still, it is hard for some investors to let go of the idea that it should be relatively easy to beat the market. Even while expressing frustration with the stock market, some people find trading to be exciting. Likewise, it should be obvious that the prospects of certain companies or industries are either bright or fading. And the logic of index funds themselves (the index is the average of all market participants, so by definition the index will beat half of the participants, and index funds’ lower expenses mean that index funds will beat even more participants with higher expenses) leaves the possibility that some market participants will beat the index. With a little work and a little luck, why can’t I be one of those market-beaters?

So, with some reluctance and the strongest possible disclaimer that we do not endorse trading, here are some things to consider if you must actively try to beat the market.

Start small and/or control the risk – Cordon off some small part of your overall portfolio to test trading techniques and avoid big losses. Rather than using “stop loss” orders to limit risk (in which a holding is automatically sold if the price drops below a certain level), consider using “alerts” which are available free on most financial websites. You’ll be notified if the price drops and then you can decide whether your rationale for making the investment has changed to the extent that you want to sell or if the drop is due to an overall market decline.

Have some kind of plan – Decide upfront how long you want to commit to trading, some range of tolerable loss and the process by which you plan to buy and sell. Most importantly, write it down and refer to it often. Otherwise, you are conducting a potentially very expensive experiment in random events.

Don’t be a closet indexer – It is estimated that 30 to 40 stocks are necessary to diversify the “company-specific” risk that any one holding will take down the entire portfolio. Conversely, don’t own so many stocks that you diversify away the chance to beat the market, which is the whole point. If you’re not willing to take some chances, just use indexes. If you want to use some actively managed funds in which the fund manager is making investment choices, look at fund expenses (lower is better), turnover (how often the fund changes its holdings, and lower is better here, too) and the extent to which the fund differs from the overall market. “Active share” measures the percentage of a fund’s holdings that differ from its benchmark index, and a higher active share increases the likelihood that a fund will either beat or lag the index.

Consider a newsletter – There a plenty of newsletters out there, and the best rule of thumb is to avoid those with the greater amount of CAPITAL LETTERS and !!!’s. Evaluate a newsletter on how well it fits with your own thinking and whether its recommendations make sense rather than on performance claims which are often selective at best. If you decide to follow a newsletter, follow all its advice and don’t try to second-guess or cherry pick the recommendations.

Benchmark performance – The most dangerous result is to have a great success with your first trade and then to project those results far into the future. The next greatest danger is to credit results to your genius when it may be due simply to a strong overall market. Comparing all of your trading (not just the successes) to the overall market will make clear whether the trading was worth it financially. Then you can add some factor for the time and effort spent as well, which may be positive if trading gives you a thrill or may be negative if you have better things to do with your time.

If all these considerations make beating the market seem like too much work for no guarantee of success, then we have succeeded at our job.