The Markets	09/30/16 Close	06/30/16 Close	3rd  Qtr. Change	09/30/15 Close	12 Mo. Change	YTD Change
Dow	18,308	17,930	+2.11%	16,285	+12.42%	+5.07%
NASDAQ	5,312	4,843	+9.68%	4,620	+14.98%	+6.09%
S&P 500	2,168	2,099	+3.29%	1,920	+12.92%	+6.01%
MSCI EAFE	1,702	1,608	+5.85%	1,644	+3.53%	-0.82%
10-yr Treas. yield	1.61%	1.49%	+0.12%	2.06%	-0.45%	-0.66%
Fed funds rate	0.25% to 0.50%	0.25% to 0.50%	n/a	0 to 0.25%	+0.25%	n/a

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

Unlike the previous quarter, this period got off to a strong start before somewhat fading towards quarter-end. Still, the quarter was positive, with growth stocks returning to lead the US market and international stocks continuing their recovery. Interest rates followed a similar pattern, falling after the Fed chose not to raise rates at their September meeting. Some money market investors actually saw some funds begin to pay some income after years of nearly none, due to regulatory changes that require higher quality in funds linked to brokerage accounts. This change brought selling pressure and higher yields on short-term corporate instruments that were previously the lifeblood of money market funds.

The US stock market is actually shrinking as the number of publicly-traded companies has fallen 46% in the last 20years; the peak was 8,025 companies in 1996 and is now around 4,333. The cost of raising equity capital has gone up with increased regulation, volatile markets are scaring some companies from going public, and it is easier to raise non-public capital.

Second quarter GDP growth first came out at 1.2%, below expectations of 2.6% and accompanied by a downward revision of first quarter growth from 1.1% to 0.8%. Inventories fell for the first time in five years, putting a damper on growth as businesses did not stock as much goods. Several revisions later and 2Q GDP growth came in at 1.4%, boosted by a 1% increase in business capital investment and strengthening consumer spending growth of 4.3% from 2015. One measure of consumer confidence reached a nine-year high of 104.1 after falling as low as 25 during the recession. Fed chairman Yellen expressed confidence from strengthening in the labor market and the economic outlook.

Job growth continued its positive but bumpy path. Weekly jobless claims hit a 43-year low and were below 300,000 for over 80 weeks straight. July job growth was very strong but both August and September fell short of expectations. Unemployment rose to 5% but that was seen as a positive as the increase was due to more workers looking for jobs and the labor participation rate finally edging upward. While the Fed was delaying what is generally seen as an inevitable rate increase (and even saying they have not considered negative interest rates to spur growth), the Bank of England cut rates to historic lows to cushion the Brexit shock and the Bank of Japan set a target of keeping 10-year interest rates at zero. This stated rate target is a unique tactic since central banks typically announce their bond-buying programs but leave interest rates to the markets.

New home sales in July were the best in nine years but house prices in general have hit relatively high levels compared to rent (the ratio of prices to rent is 16% higher than the 40-year median) and salaries (prices compared to average weekly pay for non-supervisory workers is 22% higher than the long-term median). Home ownership is at 1965 levels but household formation is strong, with all those new household basically becoming renters. New home sales are up 20% from a year prior (with median prices slightly lower) and existing home sales are up 3%, held back by low inventory (prices are u about 5%).

Other measures of economic activity stayed slightly positive for the quarter with manufacturing being the most anemic. After-tax corporate profits were down 2.4% after an 8% increase in the first quarter. Food prices declined for a full year, the first time in 50 years, due to the strong dollar, weak Chinese demand, low fuel costs and increased supply. Wells Fargo was caught red-handed, and fined $185 million, for sales practices which resulted in accounts being opened without customer permission. Congress reached a budget deal to avoid any government shutdown and included funding for the Zika virus and flood victims. OPEC uncharacteristically announced a cap on its oil production, lifting oil prices to around $50.

The Brexit drama settled down considerably as Theresa May became Prime Minister in July and the leadership void was filled. She has announced that Brexit will proceed and the two-year clock will likely begin in the spring. The political stabilization did not, however, stop the slide of the British pound, which fell to an all-time low against a trade-weighted basket of other currencies. There were other political surprises, including a failed coup in Turkey that has shaken things up even further in the incredibly complicated Middle East. The most recent upset was the failure at the polls of Colombia’s peace deals to end the 40-year war with leftist rebels who morphed into drug dealers. Unpredictability abounds.

Looking Forward

It is nearly impossible to ignore the two elephants in the room – the November election and the possibility of an interest rate hike by the Fed. Both have shown up in this section before but both have also heated up considerably.

Our position is that the only thing the election will resolve is that it will be over. Many people are “nervous” but we’ve yet to figure out exactly what that means or what they or we should do about it. So, we focus on two things: 1) there have always been and always will be reasons to be
“nervous”, the world is complicated and dangerous even when in hindsight things looked positive and 2) we look way past the election to the long term. There will no doubt be some immediate reaction but that will quickly settle down.

Data bears us out, both before and after the election. Recent analysis of market sectors that should benefit from a particular candidate taking the election shows no connection between that candidate’s ebb and flow and the sector performance. There is also very little correlation between market performance and the results of a presidential election (actually, markets have tended to do better during Democratic presidencies, but the cause and effect is not clear). In layman’s terms, presidents probably get too much credit for positive markets and too much blame for poor markets.

Rate hikes are different. The low rates and their effects have to end at some point (when??) and everyone knows it’s coming. It’d be great if there was a soft landing (the first rate hike was a non-event) but we’re hard-pressed to really recall a soft landing from such a big shift.

Higher rates should really begin to have an impact when either or both of two things happen. One is if higher rates begin to cramp borrowing and tightening money. We have not heard any instances where a small increase in rates has made a project less feasible and other measures by the government are keeping money loose. The second is if rates rise to the point where the risk/return analysis between stocks and income investments shifts in favor of income investments. Again, a small increase in rates may make traders nervous but for most investors the dividend yields will still make stocks attractive.

So, except for mortgage refinancing, another small increase in rates should be easily digested. But who really knows?

Our Portfolios

If you are a regular reader of this section of the Review (or if you’ve even read it more than once), you may find yourself thinking “great, here Dave goes again. He’ll talk about some investment or portfolio management topic but then dismiss it in favor of sticking with a long-term allocation.” And that may leave you wondering exactly what these guys do in managing a portfolio.

The answer is that there is a lot more work that goes into investment management than changes in the portfolio. For example, a client recently came to a review meeting with an article from Barron’s on “low-volatility” funds that are made up of stocks that tend (my emphasis added) to swing less than the market as a whole. These funds also tend to be heavily weighted in sectors such as health care, financials and consumer staples. And as of early May, when the article was written, these funds had indeed outperformed the S&P 500 so far in 2016.

As it turns out, Denis had just the week before done an analysis on new exchange-traded funds, how they reflect market trends and how they had performed in terms of market acceptance and investment returns. In addition to the risk noted in the Barron’s article, it was pretty clear that early investment returns for many funds were driven by surging investor interest, which drove up prices for some stocks in a period of low market volatility. In other words, if the markets are relatively calm, even a small increase in demand can push prices higher.

We were not convinced that low volatility, smart beta (which uses a set of investment rules, rather than market capitalization, to construct an index) or any of the other trendy strategies added long-term advantages that would not be captured by owning more broadly diversified funds through long investment cycles that may favor one area over another. Eventually those areas all “regress to the mean” and fall to the overall market return, adjusted for growth and income potential. And sure enough, this fall many of the stocks and sectors that had been driven up in price fell as traders took advantage of higher prices and sold. Ironically, that left “low volatility” investors unwittingly exposed to significant volatility and some of those investors abandoned the strategy at probably the exact wrong time.

Much of the market, portfolio and investment analysis we do is behind the scenes and does not necessarily result in a change to portfolios. While we can’t possibly analyze every possible investment out there (who can?) we do have an obligation to invest our clients’ portfolios in accordance with their goals. Those goals are long-term financial well-being, which requires resolve and discipline, rather than trying to “beat the market” or provide some level of excitement.

The Big 4-0

While it has received quite a bit of press recognition, it is still worthwhile to acknowledge the 40th anniversary of the introduction of the first index fund that was made available to individual investors. The Vanguard Index 500 Fund, which mimics the S&P 500 stock index, was the brainchild of John (Jack) Bogle, the chairman of the Vanguard Group. (Full disclosure: I had the pleasure of serving as Jack Bogle’s assistant in 1987 and 1988.)

The fund opened with a measly $11.3 million in assets and the reception was cool, to say the least. The mutual fund business was overshadowed by daring fund managers who at times posted spectacular returns. The index fund was called “un-American” and a way to settle for mediocrity. The idea of index funds grew slowly, with all index funds reaching $511 million in 1985, and then took off, growing to $55 billion in 1995.

The advantages of index funds are pretty straightforward. First, any market’s return is the sum of all its participants, but this is before any costs. An investor with low costs has a significant advantage over a participant with higher costs, and index funds have a fraction of the costs of actively managed funds. Second, index funds have “relative predictability”, which means that even though the market is unpredictable an investor can be sure that wherever the market goes, his fund will go, which allows a better assessment of risk and potential return. Active funds have the added unpredictably of the manager’s selections of sectors and individual companies.

And so the march of index funds continues. In addition to providing solid investment returns, index funds have drastically cut the costs of investing in funds. There has even been a price war of sorts with index exchange-traded funds (ETF’s) available for as little as 0.04% a year, or $4.00 for every $10,000 invested. At the same time, some brokerages are waiving transaction costs for some index ETF’s, lowering the cost of investment even further.

All is not perfect in the index world, however. Some market observers are concerned that as index funds represent a larger share of the market, there will not be enough active trading to allow stocks to reach a true equilibrium value, which is a critical role of markets. In theory this could happen, but index funds still represent less than 25% of total US stock market value and would have to greatly increase that share to hinder market pricing. By that point, it becomes even more likely that active traders will sense an opportunity to take advantage of pricing anomalies, restoring proper pricing and muting the impact of indexing.

Of course, investment marketers have gotten into the act and created index funds that track ever more obscure and focused indexes and have also created “custom” indexes to reflect their investment theories. These index funds have higher costs, less predictability and poorer tracking of the underlying index than more diversified index funds. There are plenty of warnings about the risk of these obscure index funds but some investors just can’t resist. Fortunately, the large diversified funds are more widely available and are attracting most of investors’ assets.

Little wonder the tidal wave of money flowing into index funds has continued to build. In 2015 index funds took in $576 billion more than funds with active managers who select stocks or bonds in pursuit of higher returns and/or lower risk. It is encouraging that investors have fully accepted index funds and hopefully they won’t abandon the funds and their inherent advantages if there comes a period where active management somehow outperforms.