The third quarter marked a resumption of the upward move in the price of “risk assets” as stocks across most markets were strong after some weakness in the second quarter. Emerging markets led the parade with a total return of 7.7%, but developed international markets and the US stock market weren't far behind with total returns of 6.9% and 6.4%, respectively. Although real estate, as measured by REIT indices took a breather in the quarter (+1.9%), it still has the best year to date return at 17.6%. The year to date total returns for domestic indices are in the mid-teens (+16.4% for the S&P 500) with international benchmarks trailing that, but still in double digits. This represents the second best total return for the S&P 500 after the first three quarters of the year since 1998 (the best was the bounce off the bottom in 2009).
With nothing to go on but this return data, one might assume the economy has been gaining momentum and employment is growing strongly, that the sovereign debt crisis in Europe has been resolved, and/or that the domestic deficit problems have been addressed. But sad to say, none of these things has happened. What has happened is that the European Central Bank and the US Federal Reserve have both made promises to purchase huge amounts of government bonds suggesting unlimited liquidity as far as the eye can see. From where we sit, this would be more encouraging if the US were suffering from high interest rates or if easy money was a cure for insolvency and a lack of competitiveness in Europe. But we aren't convinced that highly aggressive monetary policy is the right treatment for our current maladies. Even the best cancer drug will do more harm than good for a patient who has heart disease (rather than cancer). We fear that in the long run, the primary harmful side effect of Chairman Bernanke’s easy money treatment for the economy will be inflation. So we continue to monitor gold prices and other alternatives for an opportunity to add additional inflation protection to portfolios.
We also remain focused on protecting portfolios against the unusually wide range of risks we see in the current environment. We are pleased that portfolios have participated in most of the upward move in the markets, despite our focus on portfolio protection. We also remain watchful for developments on the tax front as we approach year end. In some circumstances it may make sense to accelerate the realization of capital gains in the current year, especially in the case of concentrated positions.
Given the equivalent of a couple of years of stock market returns in the first nine months of the year and very modest improvements in the underlying fundamental backdrop over that period, stock market prospects have deteriorated. Consequently, we’re aggressively rebalancing portfolios back to equity targets and looking carefully at whether to move under those target weights.