My F&M

Market Commentary 3rd Quarter 2014

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Stocks took a breather in the third quarter as the S&P 500 returned just over 1%, while small cap stocks fell along with both developed and emerging international stocks.  Nonetheless, the S&P 500 has still managed a total return of 8.35% for the year to date, and bond indices have produced healthy returns in the 4% area.  

Bond indexes produced remarkably similar total returns to the blended stock benchmark this year (4.41% for taxable bonds, 3.75% for tax free bonds), while real estate (as measured by the REIT index) has been the best performer, after a weak 2013.  In spite of generally weak commodities prices this year and weak gold prices last quarter, our inflation hedge positions in aggregate have been strong this year led by MLPs and energy royalty trusts.  Lastly, insurance-linked securities have performed well, besting all bond sub-categories this year to date while providing unmatched diversification.  

This year to date (through 9/30), the total return of our standard blended stock index (60% large US, 15% small US, 15% established international, and 10% emerging international stocks) was up 4.36%, as the S&P 500 Index gained 8.35%.  Diversifying stock exposure away from large US companies and into smaller US stocks and international stocks has not helped performance this year.  In fact, it has not helped performance over the 3 years or 5 years ending 9/30!  We remain committed to diversifying stock exposure with both smaller and international companies while recognizing that from time to time there are lengthy periods in which such diversification will lag the S&P 500 in performance.  The last such extended period was in the “irrational exuberance” era of the late 1990’s, a period with some uncomfortable parallels to the current environment.  As you may recall, that episode was followed by years of much better relative performance from our diversified stock strategy (as well as from value, yield, and quality – three of the cornerstones of our equity approach).  

Looking forward, high stock valuations persist by virtually any long term measure and the extraordinary policies of the Federal Reserve in recent years have almost certainly created substantial financial market excesses (the details of which can only be fully known after the fact).  On the other hand, both inflation and interest rates remain low (at least for now), and seasonality is now turning positive (more on that will be coming in a separate report).  We are keeping portfolios positioned relatively defensively, yet we are happy that markets have offered some gains this year so far.  At this point, emerging markets stocks and private real estate appear to offer the best opportunities for future returns.  

Stock market volatility has kicked up in recent weeks, and that could be a precursor to a market correction.  But if that were to happen, we would consider that both an overdue and, in the long run, a healthy development.