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October

THIRD QUARTER FINANCIAL MARKET COMMENTARY

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Third Quarter 2014 Financial Market Commentary

October, 2014

 

Time is on the Fed’s Side

The S&P 500 Index generated a 1.13% total return in the third quarter for its seventh consecutive quarterly gain as

evidence of an improving economy emerged with second quarter Gross Domestic Product (indicator of economic growth) coming in at 4.6%. The remainder of broad risk-based asset classes and investment grade corporate bonds posted negative returns for the quarter (See Tables #1 & #2). Investors became more focused on geopolitical events in the Ukraine, Syria, Iraq, and Hong Kong combined with the uncertainty of when the Federal Reserve will begin raising interest rates. Historical correlations among different asset classes didn’t seem to matter much as the financial markets went from Risk-On to Risk-Off trades.

 

TABLE #1: 2014 3rd Quarter and 1 Year Ending September 30th - Asset Class Index Returns*


Large Cap Equities Mid-Cap Equities Small Cap Equities Int'l Equities Emerging Equities

Intermediate

Bonds

High Yield Bonds

MLPs

Real Estate

(REITs)

Commodities Cash
 3Q 2014  1.13% -3.98% -7.35% -5.72% -3.33% -0.03%  -1.91% 2.66% -2.48% -12.46%  0.01%
 1 YR Ending 9/30/14 19.72% 11.78% 3.94% 4.96%  4.64% 2.39%     7.14% 25.80%   13.17% -7.76% 0.05%

 

TABLE #2: 2014 3rd Quarter and 1 Year Ending September 30th – Bond Sector Index Returns*


U.S Treasuries 1-10yr U.S. Agencies 1-10yr Corporate Bonds 1-10yr Mortgage-Backed Securities (MBS) 0-10yr Municipal Bonds 1-10yr






 3Q 2014  0.01% 0.03% -0.12% 0.15% 0.63%




 1 YR Ending 9/30/14 1.19% 1.48% 4.75% 3.72%  3.67%




*Source: Bloomberg and Bank of America/Merrill Lynch Indices

 

In times of heightened volatility, it’s important to take a step back and reflect upon where the financial markets and economy have been the past 5 years. Since the financial markets began rebounding in March of 2009, investors have repeatedly misjudged the risks of inflation and higher interest rates. They have also underestimated the central banks’ ability and desire to keep the world economy stabilized. Led by the U.S. Federal Reserve (Fed), central banks in Europe, Japan, and China have kept interest rates low and pumped trillions of dollars into the global economy. Many believed that these unprecedented actions had to produce inflation and lead to much higher interest rates. In reality, inflation has remained low, economic growth has been slow, liquidity has been abundant, and stocks and bonds have performed extremely well.

 

Inflation, interest rates, and bond yields have all been persistently low for several reasons. Aging demographics, the impact of deleveraging (paying down debt), cheap global energy, global competition that holds down wages, excess production capacity created by technological innovation, and an abundance of global savings have all contributed. But the primary reason is that after the near-collapse of the world’s financial system in the fall of 2008, the economic recovery has been extremely slow and uneven.

 

The Fed’s massive injection of money into the financial system via monthly bond buying hasn’t created inflation because there has been a lack of demand for credit. Businesses have been holding down wages and avoiding investment spending which in turn has boosted profit margins to record levels. Employees have endured slow wage gains and weak hiring which has further enhanced corporate earnings and helped to boost stock prices to the detriment of consumer incomes and spending.

Until the third quarter, stock markets around the world had been rallying almost non-stop since October of 2011. Stocks remain in a sweet spot because the economy is slowly recovering, there is plenty of liquidity available thanks to easy monetary policy, and inflation remains low. While the Fed is on schedule to finish monthly bond purchases this month, Fed officials have gone out of their way to reiterate that interest rates will remain low for quite some time. Corporate earnings continue to be strong. From a valuation perspective stocks are no longer cheap, but as long as the economic recovery stays on track, valuation is not a risk. Stocks continue to offer higher relative value than bonds or cash.

During the quarter, the following tactical moves were made across all asset allocation strategy accounts greater than $150,000. First, we sold all exposure to the Real Estate (REITs) asset class. This tactical move was precipitated by the extremely rich valuation level reached by the Real Estate (REITs) sector this year. REITs, as measured by the FTSE NAREIT All Equity Index, currently trade at greater than a 50% premium to their trailing 10 year price average. The following week we initiated a position in AMLP (Alerian MLP ETF) across all asset allocation strategies for accounts greater than $150K. The purchase was funded using cash from the sale of REIT ETFs. MLPs (Master Limited Partnerships) provide attractive relative yields with low historical correlations to stocks and bonds. We were able to significantly improve the dividend yield versus REITs as AMLP currently yields 5.96%. MLP funds provide exposure to a well-diversified basket of individual MLPs. AMLP holds U.S. Large and Mid Cap energy stocks of companies that earn the majority of their cash flow from the transportation, storage, and processing of energy commodities. The holdings are weighted based upon market capitalization.

As we begin the fourth quarter, the U.S. economy has emerged as the developed world’s growth leader with the Fed being the first central bank to end Quantitative Easing (bond buying) later this month. Europe continues to be fundamentally weakened by the sovereign debt crisis and a fragile banking system. The Bank of Japan’s efforts to

reflate their economy seem to be waning and growth in China continues to decline. Investors are confronting geopolitical instability and the end of Fed stimulus.

The impact of geopolitical tensions in the Middle East, Hong Kong, and the Ukraine is difficult to assess. We know that stocks hate uncertainty and volatility could certainly be on the rise as these situations play out in the coming months. The consensus view among investors is that a correction in prices is imminent. A correction, one which we believe will be less than 10%, is long overdue and much needed. However, it would be difficult for a significant correction to occur given that talk of a correction is so prevalent. Sizable corrections typically occur as a result of actions that surprise most investors.

Our outlook on the financial markets from the start of the year has not changed. We believe that stocks will continue to outperform bonds and cash this year. In our view, the biggest risk to the financial markets is any shift in the current monetary stance by the Fed. The Fed remains very transparent and measured in its actions and statements. Either the unprecedented, highly accommodative monetary policies by global central bankers will be successful in generating a sustainable acceleration in economic growth or these central banks will have to undertake even greater and longer support of the financial markets. Right now the Fed Funds Futures markets are predicting the first increase in interest rates by the Fed will not occur until June of 2015.

We believe that time is on the Fed’s side with respect to when interest rates need to be raised. It will be difficult for U.S. economic growth to accelerate at a sustainable pace given the current economic weakness that exists in Europe, Japan, and China. In addition, the economic fundamentals in the U.S. still lack clarity. By in large, economic growth during the first half of this year was disappointing. Weak credit demand remains an issue for the U.S., as well as the world economy. Consumers and businesses continue to be reluctant to take on more debt. As a result, aggregate demand growth has been subpar. However, corporate earnings growth has remained fairly solid. In order for stocks to continue moving higher in price, we’ll need to see economic growth accelerate. The U.S. economy is in the middle innings of the business cycle. Consumer and corporate spending typically begin to increase mid-way through the cycle so we’ll look for signs of this as we move forward.

 

Andrew Zimmerman – Chief Investment Strategist

Notes: The DT Investment Partners’ Commentary and Outlook discusses general developments, financial events in the news and broad investment principles. It is provided for information purposes only. The material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. Investments in various asset classes entail different investment risks. For example, small cap stocks tend to be more volatile than large or mid-cap stocks. International and emerging markets stocks have exposure to currency fluctuations, foreign taxes, political instability and the possibility for illiquid markets. Fixed income investments involve interest rate and credit risks among others. Real estate investing includes risks such as declines in value of real estate, changing economic conditions, tax laws or property taxes. Commodities’ investing is highly volatile and subject to changing economic conditions and the vagaries of speculators among other risks. Further, diversification and strategic or tactical allocation do not assure profit or protect against loss in declining markets. Index performance returns do not reflect any management fees, transaction costs or expenses. One cannot invest directly in an index. Past performance does not guarantee future results.

 

Luke Johnson is a Registered Representative of Coastal Equities, Inc., and an Investment Advisory Representative with Coastal Investment Advisors.  1201 N. Orange St., Suite 729, Wilmington, DE 19801. Securities are offered through Coastal Equities, Inc.  Member FINRA

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