Monica Knowles |

Neil D. Paolella, CPA    October 2018


Stocks had their best third quarter since 2013, entering the fourth quarter of 2018 near all time high levels, but under a cloud of turmoil caused by accelerating interest rates, inflation, a contentious presidential mid-term election and an international trade fight with China.  The S&P 500 gained 7.2% in the third quarter, its best performance since the end of 2013.  That left this popular US index up 9.0% on a year-to-date basis at September 30.  The Dow Jones Industrial Average climbed 9% during the quarter, pulling this index into the black for the YTD, up 7.0%.  The Nasdaq Composite rose 7.1%, extending its streak of gains to nine consecutive quarters and putting it in double digit gain territory for 2018, up 16.6% YTD.  These major stock market indexes ended the quarter within 1% of their all-time highs.  Small stocks also participated in the good news, but lagged a bit, only up about 3%.  However, through the first 9 months they are up a respectable 10.5% as measured by the Russell 2000 index.


Outside of the US, almost every market is down, and down significantly.  The strong dollar has been a major factor, as the actions of our Federal Reserve Bank reversing eight years of monetary policy accommodation while raising interest rates take effect.  This depresses the share price of foreign stocks (after price conversion to US dollars) and causes US investors to pull back on their overseas holdings.  In addition, many foreign businesses, especially in the emerging markets, borrow money denominated in our currency.  When the dollar rises in value, it makes their debt payments more expensive. Finally, the pro-growth policies of the current administration has provided a tailwind for domestic companies and stands in  stark contrast to just about every economy outside of our borders, attracting investors into the US.


A storm of events arriving in the first 10 days of October overshadowed the third quarter’s good news, bringing a violent and sudden drop in both stock and bond prices.  In just two back-to-back trading days, the Dow Jones fell 1400 points (about 5%), while the Nasdaq Composite plunged over 8%, led by steep selloffs in the popular “FAANG” stocks- Facebook, Amazon, Apple, Netflicks and Google.  The two day carnage gave us the worst start to October since the 2008 financial crisis. The chief culprit behind this upheaval was a sudden surge in interest rates, coupled with an unsettling announcement from our Federal Reserve Chairman Jerome Powell, taking investors by surprise.  Global markets, which had badly lagged behind our domestic markets all year, fell a similar amount as the panic spread worldwide.


Fed Chair Powell’s Comments Ignite Global Conflagration

A tsunami of worry was created when, just a few days after hiking short-term interest rates another 0.25% on the last day of September, in a widely watched TV interview our Federal Reserve Chairman Jerome Powell said that “we’re a long way from neutral at this point, probably”.  This comment was akin to someone yelling “fire” in a crowded theater.  His comment indicated that the Fed’s path forward in increasing rates was likely to be at a faster pace and more agenda driven than data driven, something the financial markets did not expect nor want to hear.  A rush to the exits ensued.  So, what exactly is “neutral” in Fed-speak?  It’s a theoretical point where the Fed raises short term rates to where they would be naturally, without Fed intervention.  Rates above neutral signify tight policy, while rates below neutral imply loose or accommodative policy.  The problem with this is that no one really knows exactly where neutral actually is!  And therein lies the issue- attempts at finding neutral have historically been a hit or miss, with several large upside misses that have caused our economy to fall into a recession when rates were pushed too high.


It’s Not How You Start, It’s how you Finish that Counts.

Concurrent with the Fed raising short-term rates and Powell’s Faux Pas, both mid and long-term rates spiked. The 10 year Treasury bond yield eclipsed 3.25%, its highest level in about seven years, up from 2.85% just a month or so ago.  The rapid rate of change unsettled the markets, causing most all types of bond prices to fall significantly.  Investors are worried that the Fed, who has a history of going too far and too fast with rate increases, will deliver another expansion ending policy mistake, and rather than engineer a soft landing, will push our economy into a recession.  Recessions always exact a toll on the price of stocks.  Rising interest rates don’t have to hurt our economy, so long as they are increasing for the right reasons- robust growth in the economy. It’s when they are advancing due to Fed over exuberance, or because of high inflation that inflicts damage.  A gradual and data driven pace of rate change is the key.


Will a Mid-term Melee affect Financial Markets?

The usual political bickering in Washington, along with the coming midterm elections, can largely be dismissed as “noise” by investors, who are focused more on data showing a robust pace of job creation and economic expansion.  History shows us that a split Congress has little effect on financial markets, so should the majority in the House of Representatives change to Democrat, it shouldn’t affect things positive or negative.  If the House and the Senate change leadership, then we could see an end to the pro-growth policies currently in force, and this would likely cause weaker financial markets.  Few analysts predict a change in the Senate, so the coming election is not likely to be a factor for investors.


Market Outlook

This market, like all markets, care about two things- the price of money (interest rates) and return on capital (growth). With the reversal of an accommodative money supply and increasing interest rates, the Fed is no longer providing a wind at our backs, so we need growth in the economy to advance stock prices.  With the tax cuts passed last December, and the pro-growth agenda being implemented by the present US administration, the case for growth is in place for 2018.  However, two things have recently changed- interest rates have started to surge and international growth prospects have slowed drastically.  The China trade tariff situation has not helped the latter.  Here is the bottom line- investor’s fortunes in the next year are in the hands of our Federal Reserve and with President Trump’s handling of the trade skirmish with China.  If the Fed behaves, and the China situation sees some material resolution, markets will advance. 


Portfolio Strategy

We have not made significant changes to our portfolio strategy since the 2016 presidential election, where we increased our risk level and emphasized large cap stocks, both which has proven beneficial.  We also have benefitted greatly by what we don’t own, and that is international stocks, which as a group have lost significant money this year.  Considering the risks that are posed by rapidly increasing interest rates and given the history of Fed overreach, we are now on alert.  Economic growth has to eclipse the headwinds caused by the increasing cost of money, so the sledding gets more difficult from here.  As this is being written, we believe that the Bull market case is intact for the near term, as Bear markets don’t start with a bang, they sneak up and start stealthily, catching investors unaware.  However, as the risks have increased, we can envision a strategy change in the coming year.  It all depends on the data and Fed action.                      


As always, if you have any questions regarding the above or your investment accounts, please contact us at your earliest convenience. 

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