From our 4th Quarter Newsletter...
September is usually one of the worst months of the year when it comes to stock market performance. How then did this most recent September post the best results for a September in four years? In fact, the two months of August and September were the best August and September in nearly 80 years. On top of this, the quarter ending September 30th was the 8th consecutive quarter to post positive results marking the first time in 20 years that we have had such a winning streak.
If we stick with historical indicators, 80% of the time the 4th quarter is positive following a strong third quarter. While statisticians would usually bet on a strong 4th quarter given recent results, that same statistician would have sat out most of the summer rally given historical results.
Is the current bull market ready to succumb to the bears?
To answer this question, we first need to understand the impact of Quantitative Easing by the Federal Reserve and other major Central Banks of the world.
Since the Great Recession, the Federal Reserve has been pumping money into the economy by buying lots and lots of bonds. Called Quantitative Easing, Federal Reserve actions have helped keep interest rates near historic lows. This extra cash in the economy has spurred business spending, job creation and stock market values. The key risks to this strategy relate to the Federal Reserve continuing these accommodative policies for too long. If that were to happen, the dollar would decline in value while asset values like real estate or stocks would rise to unsustainably high levels.
Federal Reserve Chairperson Janet Yellen has stated that the Federal Reserve will begin ending Quantitative Easing this quarter. The idea is that the Federal Reserve will slowly start selling some of the $4 trillion in bonds that they hold. These sales should cause interest rates to go up.
Given these extraordinary policies by the Central Banks of the world, there is real concern that interest rates could rise very quickly if the sale of debt back into the markets by the Fed and other Central Banks goes poorly. When the Federal Reserve first mentioned their intent to discontinue Quantitative Easing back in 2013, the market panicked and investors began selling their debt holdings thus pushing rates higher far faster than the Federal Reserve wanted. As a result of that Taper Tantrum, the discontinuation of Quantitative Easing was delayed until now.
A key problem caused by higher interest rates is that current debt held by investors is worth less if sold prior to maturity. As an example, if an investor was to sell a $1,000 bond that paid 3% over five years after interest rates rise to 5%, that investor would have to reduce the principal value of their bond by 2% per year over the remaining life of the bond in order to find a buyer. Stated differently, the investor might have to take a 10% haircut on their bond (2% over 5 years) or $90 in order to find a buyer. Longer dated or lower quality bonds would see their values drop even more.
Higher interest rates mean that the interest yield on a Mutual Fund or Exchange Traded Fund made up of bonds will go up although the value of the underlying investment will most likely go down. Eventually, the principal value of the funds will go back up but that might mean that the investor has to hold that investment far longer than they wanted to. In order to minimize the negative impact of rising rates on fixed income bond holdings, investors are advised to reduce the time to maturity on their funds while increasing the quality of the fixed income held by those funds.
Due to the extraordinary interventionist policies of the world’s Central Banks, interest rates are artificially low while asset values are artificially high despite the highest debt levels in the history of the world. The Federal Reserve and world Central Banks now have a huge challenge in removing easy money from the financial markets without causing large drops in the values to stocks, bonds and real estate. Can it be done without market disruptions? History suggests that the unwind will cause unexpected results and increased market volatility.
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