3rd Quarter Commentary: An Affair to Forget


In case you’ve missed the financial news over the last three months, Q3 was a pretty ugly affair in world markets. Almost every equity and commodity category – domestic and international – started the quarter still in the black for 2015 but all of those categories ended the quarter solidly in the red for 2015. Most of the losses can be pinned to two proximal causes: growth worries out of China, which are really a proxy for growth worries everywhere, and continuing uncertainty over a Fed rate hike here in the U.S. (Will they or won’t they?) These concerns spilled over into all economies and markets, both developed and emerging, and hit the commodities sector especially hard. Oil prices fell 25% during the 3rd quarter, and the broad Goldman Sachs Commodity Index fell 19%. Although those specific areas/sectors were hit particularly hard – as was China, with a 29% drop in the Shanghai Composite Index, many broader equity indices didn’t fare quite so poorly: Large US and European stocks were down between 6% and 9%, while the MSCI broad index of Pacific stocks was down about 13%.

Despite the downbeat news in the markets, the US economy still remains poised to grow 2.6% this year, which would be its best year since 2006 as consumers continued to spend at a reasonably strong clip, powered by two forces: a strong dollar, which has increased purchasing power of imported products, and falling oil prices (every cloud has a silver lining). Housing activity and prices have continued to rise, with the S&P Case-Shiller home price index posting a 4.7% year-over-year rise through July, although the pace of new home sales slipped a bit in August. Furthermore, household net worth is at an all-time high ($85.7 trillion), whether measured in nominal, real, or per capita terms; household balance sheet leverage has fallen by more than 30% since the 2009 peak; and the economy has been growing and jobs have been expanding for more than six years…and although Friday’s jobs report was a little disappointing, buried in that same report was this encouraging fact: the U-6 unemployment rate, which measures both unemployment and underemployment, dropped 0.3% to 10%. That is very close to full employment levels; the U-6 rate was 9.5% when the Fed first raised rates in 2004, and with 5.5 million job openings, most people who want a job – or a second job – can find something.

So, Why Does Anyone Care About China Anyway?

Just as we were recovering from the ongoing and seemingly never-ending Greek tragedy in late July / early August, China’s central bank surprised many by devaluing it’s currency about 2%, under the cover of allowing the market to play a larger role in setting the Yuan’s value. This was a thin veil, though, as other motivations were likely at play – namely, improving the country’s sagging exports to help offset a slowing economy and a sharply falling stock market that had been in bubble territory for quite some time.

So, if the US economy is doing reasonably well, why have growth and market worries out of China had such a broad impact on other world markets, including ours? The short answer is that China is either the largest or second largest economy in the world, depending on how you measure it (with the US being the other, of course); the second biggest importer in the world; and the fourth largest US-export trading partner. So, the old adage, “When the US sneezes, the world catches a cold” applies equally to China sneezing, and despite a decent economic picture in the US, it did not prevent the US and other global markets from catching a cold when China sneezed.

Taking that short answer one step further, China is a huge importer of oil and almost every other commodity, and as a result, their declining demand for commodities (and for everything else they import) spills over into other sectors and other world economies, and those worries can then become a self-perpetuating cycle. Such is the nature of the ongoing and never-ending boom-and-bust business cycle, and such is the nature of the globally interconnected economic world in which we live. [1]

…And What About the Fed and the Market’s Reaction? What Is Up With That?

I’ve long maintained that even if you had tomorrow morning’s front page (or perhaps tomorrow morning’s CNN headlines), you’d still have a difficult time making much money trading on its news. The market’s reaction to the Fed not raising rates last month is an excellent example of this. In the days leading up to the Federal Reserve board meeting last month, the market rose more than 350 points as certainty increased that the Fed would probably leave rates unchanged, and when the Fed actually opted to do exactly that, the market unexpectedly dropped by about the same amount it had risen in the preceding days.

Why in the world would that be? Wouldn’t confirmation that rates would remain tethered to zero be good news? Well, again, it probably comes back to worries about global growth…it looks as if the Fed’s not moving forward unnerved market participants about the outlook for US and global economic growth more than keeping the rate low assuaged them. It makes some sense in hindsight, but I’m not sure I would have bet too much on that outcome at the time. [2]

In any case, I think when the Fed does raise rates – this year or next, it will likely be a net-net good thing, regardless of short term market interpretation, if for no other reason than to remove some of the anxiety that exists around that eventuality.

So, Tell Me Again: Why Do We Own Stocks?

Short answer? See the chart below:

Index5 Yr Return10 Yr Return
Morninstar Cash Index0.05% / yr1.19% / yr
Inflation [3]1.83% / yr2.07% / yr
1-3 Yr Global Bonds0.22% / yr3.20% / yr
Global Stocks (MS/ACWI)6.82% / yr4.58% / yr

Now, I’ll be the first to say, 4.58% per year over the last 10 years is nothing to get too excited about as an absolute return number. However, we actually live in a relative world, and most of what we need to know in terms of returns is relative to inflation – to how much prices have risen and to how much they will rise. The relatively recent historical results for an all equity index portfolio have been about 2.5% better per year than inflation over the last 10 years (and, of course, also better than other more stable options shown above – namely, cash and the Barclay’s Global Aggregate 1-3 year bond index) – and this despite a global financial crisis, the ensuing stock market crash, and the relatively anemic recovery. Said another way, to the degree an investor earned equity returns over the last five years, she saw her purchasing power grow, not shrink.

Ultimately, most retirees will need portfolios large enough to fund what will hopefully be a multi-decade retirement and all of the inflation and purchasing price increases that such a long horizon entails. Based on history, even recent history, I think it quite reasonable to expect that a healthy and balanced exposure to equities[4] is – and will continue to be – a good bet for successful funding strategy, despite the inevitable – and fully expected – ups and downs that go with such a strategy.

And Lest We Forget: What We Really Own are COMPANIES Not Just “Stocks”

When we think about stocks, or the companies underlying those stocks, I think it is worthwhile -to the degree it is possible to do so – to think about the daily stock price as a number that is separate from the actual underlying economic value of the issuing company. In the short run, stock prices – or the sticker prices that the investing world puts on a set of companies on any particular day – are much more volatile than the actual underlying and enduring values of those same well-financed and well-run companies over the long run. And what are we investing for if not for the long run?

While it’s easy to lose sight of this fact when the market is bobbing up and down – and sometimes painfully so, what we colloquially refer to as “stocks” are, in reality, fractional ownership interests in some of the largest, most entrepreneurial and most profitable businesses in the world: those same businesses that, each and every day, are engaged in an all-out war to create value, build scale, and increase market share…ultimately, to make money for themselves and for those of us who own an interest in them. To wit:

  • Wal-Mart, having just increased workers’ wages nearly across the board is now engaged in an ongoing training program for its front-line workers that, it says, will increase productivity, reduce turnover, and help more quickly identify employees capable of moving up.
  • Disney, having previously acquired Lucas Films and Pixar, will be releasing a new Star Wars movie this holiday season, continuing a franchise that came into existence when I was 13 years old and before the first VHS had come to market.
  • Schlumberger, the French oil field technology giant, announced in late August – with oil prices 1/3rd of what they were in 2007 and down again this year – that they would be acquiring oil field equipment maker Cameron for $15BB dollars.
  • And then there is Warren Buffet – who despite the global gnashing of teeth about how much further oil prices might fall, backed up the truck and bought another 3.5 million shares of Phillips 66, increasing his stake by 6% to nearly $5 billion.

So, as you contemplate the often unnerving gyrations of the capital markets (and with those gyrations, the media’s incessant din about the significance of today’s events and yesterday’s market moves), I think it also worth considering the likelihood that the actual underlying values of the 13,300 businesses a typical client owns in his or her portfolio are not nearly as volatile as the ever-changing sticker prices might lead you to believe, and perhaps more importantly, to contemplate the never-ending cycle of value creation that those companies are engaged in on our behalf, day in and day out, regardless of what sticker price happens to be attached to the market on the day you receive any particular month-end statement.

Finally, the Question Everyone Wonders About When Things Get Ugly: Should I Sell?

If I could give only one piece of investing advice and was limited to 10 words or less, it would probably be something along the lines of: “Buy, and don’t sell until you need the money.” That’s a slight oversimplification[5], but it’s gets to the heart of what I believe. Now, to be fair, buying and selling are the easy parts; it’s the “holding on” in the middle that is usually the problem. Selling when things get scary is pretty easy to do, and left to their own devices, this is what many investors would be inclined to do when the going gets rough. Interestingly enough – and perhaps not surprisingly, studies show that most investors are actually able to follow a rules-based when-to-get-out approach.

The problem comes with the buying back in part; most people have a more difficult time executing on this portion of any get-out-then-get-back-in type of strategy. If markets have gone up since the investor sold, the tendency is to want to wait until prices come back down, and if prices have gone down since the investor sold out, the world is probably an even scarier place than it was when they sold, so why not wait until the coast is clear, and stay wrapped in the warm and comfortable security blanket of cash? In most cases, getting out is a recipe for not getting back in until the train has left the station and is out of sight. This is almost always a costly mistake, and one I have seen denominated both in units of tens-of-thousands of dollars and in units of hundreds-of-thousands of dollars.

Ben Carlson, writing on his excellent blog, A Wealth of Common Sense, suggests that there are six options to deal with market downturns:

  1. Implement a strategic, diversified asset allocation approach that balances your ability, willingness and need to take risk with your long-term goals and time horizon, and manage and rebalance the portfolio in the context of that long-term allocation. [My note: This, by the way, should probably be the default option for most investors.]
  2. Implement a disciplined, rules-based approach to buy and sell at pre-determined levels or triggers.
  3. Follow some other investment process you have set up in advance that takes into account your personality, knowledge of the markets and ability to stick with the plan.
  4. Panic and sell while or after everyone else is doing or has already done so.
  5. Don’t have a plan in place and just wing it.
  6. Listen to whatever billionaire hedge fund manager is giving their latest macro outlook and follow what they say is going to happen.

Options 1, 2 and 3 are all viable choices, and there are pros and cons to each. While there are very few guarantees in investment markets, I feel comfortable saying that options 4, 5 and 6 are almost sure-fire losers in the long run, even if these options tend to line up very well with our all-too-human natural inclinations. In a recent column for The Motley Fool, Morgan Housel wrote about Navy SEAL Mark Owen. In his book about the SEAL Team 6 Bin Laden raid, Owen wrote, “one of the key lessons learned early on in a SEAL’s career was the ability to be comfortable being uncomfortable.” Being cold, wet, hungry, and tired is a normal part of the process, he writes. Rather than trying to avoid it, they learn to deal with it. At some point, whether you’re an Option 1, 2 or 3 investor, you’re going to be uncomfortable; Options 4, 5 and 6 may be easier / more comfortable in the moment, but they are almost certainly going to be costly. So, as Housel wrote, following up on that SEAL lesson about being uncomfortable: “That’s probably a good lesson for most things in life, including investing. Want to be a great investor over the long run? Get used to being uncomfortable.” While being uncomfortable is not all you need to make money investing, it is almost certainly a requirement if you want the chance to do so – and we’ve all had a chance to be a little uncomfortable this past quarter.

As always, I’m happy to discuss any of this in more detail, so please don’t hesitate to call or email if you have questions or comments. In the meantime, I hope you’re enjoying what looks to (finally!) be the beginning of some actual Fall weather.


  1. By the way, the actual economic news out of China isn’t all bad. From the Financial Times: “[While] automobile sales fell by 3.4% in August compared with a year ago, the third monthly decline in a row, other forms of consumption are accelerating. A property recovery has stoked demand for furniture, home electronics and renovation materials, with sales rising an average of 17% in August from a year earlier. From jewelry to traditional Chinese medicine, buying has picked up in recent months. Overall, China’s retail sales have increased by 10.5% in real terms this year, well ahead of economic growth.” My note: Ultimately, more of China’s economic activity has to be based on endogenous, non-export-driven demand, and activity like this is a positive sign for that much needed transition.
  2. Economist John Maynard Keynes famously wrote about a hypothetical magazine beauty contest whereby readers would vote on not whom they thought was the most beautiful model, but rather whom they thought other readers would think was the most beautiful. So, not only would the winning reader have to think about his or her own preferences, he would also have to consider what other’s think and then again about what others think about what other’s think. He likened this to investment market analysis: not only does an investor need to think about how much he or she thinks a company is worth, but how much others think the company may be or will be worth.
  3. By the way, if you want to boil broad economic demand – here or anywhere – down into one single number, that number would probably be inflation. Inflation, almost by definition, is a useful proxy for global economic demand and future expectations around that demand. In the US, for the 12 months ending in August, the Bureau of Labor Statistics reports a 1.3% rise in core prices (although it was only 0.3% if you include food and energy, as energy prices fell so sharply in the last quarter…and, if we look back to 2006, when the global financial crisis began, the pace of economic expansion (and with it, inflation as well as stock and bond returns) has been very disappointing relative to both history and the expectations of many forecasters
  4. Of course, the issue of equity vs. fixed income / stable asset exposure is something we discuss with and calibrate for each client individually.
  5. Here’s a fuller explanation of what I think it makes sense to scale down on equity exposure, or sell out of equities: 1. You need the money that is in equities, now or within the next, say, five years; 2. Your situation – and by that I mean your goals, objectives, and/or anticipated need for cash – changes unexpectedly; or 3. Your risk tolerance fundamentally changes. However, I would hasten to add that the times when you’re emotionally “hot” – e.g., during a painful market correction – are probably not the ideal times to reassess your risk tolerance. If none of those factors have changed, I’m not sure that anything that is going on in the market warrants a change in portfolio allocation, other than perhaps to opportunistically rebalance back to targets.