2014 Third Quarter Market Statistics (September 30, 2014 vs. June 30, 2014):

• Standard & Poor’s Stock Index:  1972 vs. 1960, up 0.6%
• Ten-year US Treasury Note yield:  2.51% vs. 2.52%, down 1 basis point
• Gold:  $1,209 per ounce vs. $1,322, down 8.5%
• Crude Oil:  $91 per barrel vs. $106, down 14.2%

The benchmark S&P 500 stock index advanced modestly in the third quarter as moderate US economic growth, continued low inflation, and low interest rates were set against concerns that the US Federal Reserve would move to more aggressively raise overnight interest rates against the backdrop of a weakening global economy. Bond yields were little changed as low inflation, a weak global economy, and a muted view of long term growth in the US were counterbalanced by talk of the Federal Reserve raising overnight interest rates.  Gold fell, and the dollar strengthened, on the prospect of tighter US monetary policy relative to the rest of the world, while oil fell on softening global demand and increased US supply from shale drilling.

Though the benign condition of moderate growth, low inflation, and low interest rates that has supported stocks over the past several years may persist, there are significant risk factors to be aware of:

  1. As we have written previously, a more aggressive Federal Reserve could derail the equity rally.  The market seems to be comfortable with an increase in overnight interest rates taking place in the middle of next year, with rates increasingly gradually thereafter.  If the Fed were to suggest that it is looking to increase rates sooner and faster than current market expectations, the stock market would likely come under pressure.  Additionally, large scale bond purchases by the Federal Reserve, known as quantitative easing or QE, will likely come to an end in October.  We feel QE has been a significant driver of share prices over the past two years, and the stock market may struggle with its removal.
  2. Geopolitics and global economics may not be supportive of further gains.  A heavily indebted Chinese economy is struggling to maintain its growth rate, while an already fragile European economy is coming under further strain due to American and European Union sanctions on Russia over the situation in Ukraine.  Additionally, recent pro-democracy protests in Hong Kong demonstrate the potential for political instability in China. The war against the terrorist group ISIL in Iraq and Syria could affect the global economy if fighting were to spread to the oil fields of southern Iraq, although we feel that is unlikely given the heavy support of Iraqi forces by US and allied airpower.
  3. The internal dynamics and sentiment of the market appear fragile.  First, in a healthy market, small stocks tend to lead the market higher.  Worryingly, the Russell 2000 index of small stocks has been lagging the large stock S&P 500 index significantly since the beginning of July.  The Russell 2000 actually declined 7.6 % in the third quarter relative to a 0.6% gain for the S&P 500.  Basically, investors are piling into fewer stocks, thus creating potential instability as the market becomes top heavy.  Secondly, the initial public offering (IPO) of the Chinese internet company Alibaba was the largest in world history.  This gives us cause for concern.  The stock sold represents non-voting shares in a Cayman Islands based shell company that does not actually own the assets of Alibaba.  It merely has a contractual right to a portion of Alibaba’s earnings.  We feel that the enormous size and convolution of this deal is a symptomatic of speculative excess, which is historically a negative for future market returns.

Given the risks cited above, we are cautious about the remainder of 2014. As always, we will continue to stick to our strategy of quality, value, diversification, and patience as it has served us well through both strong and challenging markets.  For the remainder of the year, we see the US stock market, as measured by the S&P 500 stock index, to trade in a range of 1825 to 2050 (currently at 1972).  We expect the yield on the ten-year Treasury bond to trade in a range of 2.25% to 2.75% (currently at 2.51%).