Third Quarter Registers Solid Gain Despite Some Banking Challenges
The S&P 500 has continued to rebound from its worst ever start to a year, with each quarter seeing progressively better results. During the third quarter, the S&P 500 moved 3.9% higher, now up more than 7% for the year and 20% above earlier year lows.
The third quarter gains did not come without challenges, however. Late in the quarter, fears of another financial meltdown began to arise due to Deutsche Bank which saw its shares fall close to 30%. The catalyst for these fears were reports that the US Department of Justice (DoJ) intended to levy a $14 billion fine on the German bank related to mortgage backed securities. With any event like this, we like to take a look at the big picture and not panic based on market gyrations. This is especially true in this case for two reasons: 1) it’s very difficult to know Deutsche Bank’s exact “system risk,” as no major bank discloses its clients or counterparties, and 2) we don’t know the amount of the final fine from the DoJ (we suspect lower than $14B). What we do know is global bank capital ratios are the healthiest they’ve been in over a decade. Stress in short-term credit spreads remains low and traditional deposits now make up 90% of all bank deposits versus only ~75% before the last crisis. These facts point to a healthy banking system, not one on the brink of collapse. In our view, much of the recent panic stemmed from fears based on the last recession rather than an objective look at the global banking system. That said, we will continue to monitor the situation at Deutsche Bank and the banking system as a whole for signs of stress.
The Economy Continues To Generate Steady Growth. Can Profits Follow?
Every quarter we like to provide an update on the economy, the single biggest factor for future stock market gains or losses. There’s good news. The US economy is still healthy and continues to generate slow, steady growth. Is it perfect? No. But the major factors all continue to point in the right direction. The labor market is generating jobs, jobless claims are low, wages are improving which is helping consumer spending as well as consumer confidence. The housing market is trending in the right direction with more qualified buyers filling homes (FICO scores near all-time highs/mortgage payments as a percent of income near all-time lows). And while the boost from low gas prices may be behind us, higher oil prices are signaling a stronger global economy. All in all, the US economy is in good shape, particularly for how far we are into an economic expansion cycle.
The strongest headwind facing the market, in our view, continues to be elevated valuations. An easy way to solve elevated valuations is through growth in corporate profits, something we haven’t seen much of since 2013. We believe profits have hit an inflection point and will improve over the next 12-18 months. With the US economy providing the foundation, improved oil prices and a weaker US dollar should benefit the energy sector and multi-national companies enough to fuel profit growth.
US Election Could Create Volatility To Close The Year, But We Recommend Seeing The Forest Through The Trees
We’d be remiss if we didn’t take a moment to discuss the upcoming election and its potential impact on the market while remaining nonpartisan. We do not have inside insight into who will win the election or how much of their agenda they’ll be able to push through Congress. We do know, though, that the market tends to be more volatile in open elections years versus non-open years. In fact, the market historically has fallen immediately following an open election and bounced between positive and negative territory over the next six months. This compares to positive one, three and six month returns after an election with a president on the ballot. We think it’s safe to say the current election has been much more contentious than any prior and thus could produce higher volatility than normal. We’d advise investors to look at the bigger picture and remember campaign rhetoric does not always equate to policy change.
Positive Market Welcome; A Resumption In Profits Needed For More Upside.
After a flat 2015 which was difficult and volatile, it’s welcome news to see positive returns year-to-date. The key for additional upside will be an improvement in corporate profits. We think the case for improvement remains strong due to steady economic growth along with higher oil prices and a more stable dollar. We also don’t expect a smooth ride, as events that rattle investors’ nerves occur regularly. As always, though, we will keep our eye on the big picture and focus on a well-diversified portfolio that can consistently deliver income.
Please feel free to reach out with any questions. We’re always here to help.
The Investment Committee
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