Market ReviewSubmitted by Karstens Investments on October 29th, 2015
By Michael D. Karstens, CFP®, AIFA®
Stock markets around the world were mixed for the quarter, but for the most part were negative. The bright spot was the large cap U.S. market, with the Dow gaining 1.87 percent, and the S&P 500 up 1.13 percent. For the year, those indexes are up about 8 percent. These returns, however, mask many negatives in other areas. For the quarter, small cap U.S. stocks fell 7.36 percent and are now down 4.41 percent for the year. Most non-U.S. stocks also posted declines for the quarter. The EAFE fell 5.83 percent, Europe was down 6.98 percent, Japan lost 2.9 percent, and the emerging markets fell 3.36 percent. Most of these losses can be blamed on the Russian situation, geopolitical problems involving the Middle East and the outbreak of Ebola. During the first few weeks of October, fears continued to mount and most stock markets declined while volatility increased. For the first time in quite some time, holding cash on the sidelines felt good. With interest rates at record lows for such an extended period, it seemed reasonable to ask the question, “Is Cash Trash?” For the better part of the past 4 years, bank accounts and money market funds have been yielding virtually zero percent. At half of 1 percent, you will double your money in 144 years. In some foreign countries, yields have actually gone negative. In other words, you pay the bank to hold your money. These ultra-low interest rates have left money investors frustrated and searching for yield. Most realize that inflation rates have been higher than the interest rates they earn, and hence, their money market deposits have lost purchasing power over the past several years.
There’s no doubt in anyone’s mind that the Federal Reserve has artificially suppressed rates (by printing $85 billion per month and using that money to buy bonds) in the hopes of raising asset prices and boosting the economy. So far, that strategy has worked. Although we completely understand the frustration and pain that investors feel today with the ultra-low interest rates, we do think there’s a more positive way to view cash, especially in an ultra-low interest rate environment. Cash isn’t just a return-free anchor on your portfolio. It does a couple of things other investments don’t. First, it lets you take advantage of future opportunities that arise while avoiding undue risk today. The return this provides is hard to calculate but it is real, and it can be huge. Warren Buffett once said, “Cash combined with courage in a crisis is priceless.”
Secondly, cash helps prevent desperate selling. Sir John Templeton used to say that there are two great ways to lose money in the stock market. You can panic and sell when prices are falling, or you can be forced to sell your holdings during a bear market when prices are down because you need the money. We believe cash helps avoid both of these unpleasant situations. So, how long will interest rates stay at ridiculously low levels? That, of course, is the trillion-dollar question. The Fed will be meeting again in just a few days from this writing, and the odds are high that an end will come to the monthly quantitative easing on October 31. From there, the focus will turn to short-term interest rates.
In earlier meetings, Fed chairman Janet Yellen stated that the Fed would wait a “considerable period” between the end of QE3 and the initial rate hike. In the March Federal Open Market Committee (FOMC) meeting, she responded to a question about her comment regarding a “considerable period” and casually stated that such a pause would last about 6 months. If QE does indeed end on October 31, the 6-month pause would set us up for a possible rate hike at the late April 2015 FOMC meeting.
The Feds have stated that they will remain flexible regarding the economy and rate hikes. If there is no unforeseen downturn in the economy, it looks like rates could be set to begin rising in the April to June 2015 time-frame.
The Fed’s median forecast for the federal funds interest rate at the end of 2015 is now 1.375 percent, up from the current rate of less than 0.25 percent. How do they get to that rate? It is fairly simple, if they raise rates by a quarter of 1 percent in April or June and then by 0.25 percent each subsequent meeting, they would end 2015 at 1.375 percent.
For the record, the Fed forecast for the end of 2016 is currently 2.875 percent, and for the end of 2017, it’s 3.75 percent. Reaching these numbers would require the Fed to implement a consistent string of quarter percent rate increases. If the economy continues to improve and hold its own, this seems entirely plausible. If this scenario plays out, many people may be surprised by the increase in interest rates. If you have not refinanced your mortgage and have a rate over 4 percent, now may be a good time to do it. If the economy begins to crater, the big question will be, “Will the Fed resume its money printing ways?”
As mentioned earlier, the first few weeks of October were difficult for stocks with most markets around the world suffering substantial losses. After several strong years for stocks, we are not surprised by the pullback. It had been quite some time since we have had a market correction, and U.S. stocks had gotten somewhat pricey. As seen in the chart below, downturns such as this are more the norm rather than the exception. Over the past 34 years, stocks have posted positive returns in 26 of these years, despite average intra-year declines of 14.2 percent. Intra-year declines of 8 to 10 percent seem to be expected. Surprisingly, intra-year drops exceeded 25 percent in only five of these 34 years. Over the past few years, stocks have benefited greatly from the Fed’s easy money policies and the ultra-low interest rates. Is the scheduled end to QE3 to blame for the recent market drop?
Certainly, the last two times the Fed threatened to take away the punch bowl, stocks suffered fairly significant declines. Many people fear that rising rates will hurt stock prices. We remain cautiously optimistic that the market could regain some luster should economic conditions continue to improve and should any of the geopolitical fears or Ebola fears begin to lessen. That being said, we remain concerned that the massive government money printing will not be without consequence. What those consequences will be remains uncertain. •