Market Update for the Month Ending October 31, 2015

Posted November 4, 2015

October sees a return of market strength
After a difficult third quarter, October defied expectations with across-the-board gains in U.S. markets. The Dow Jones Industrial Average ended the month up 8.59 percent, while the S&P 500 Index climbed 8.44 percent. The Nasdaq did the best, increasing 9.38 percent.
Performance during the month was smooth, with no significant declines for any U.S. index. Markets rose as worries from previous months gradually receded. China posted better-than-expected numbers; Europe continued to grow; and, perhaps most important, U.S. earnings reports came in better than expected. Finally, the Federal Reserve's statement about the economy at month-end was unexpectedly positive.

Fundamentally, conditions remain reasonably healthy. Corporate earnings have been strong, with more than three-quarters of companies that reported by the end of October beating earnings expectations. Additionally, the expected aggregate corporate growth rate was revised upwards, although it is showing a decline because of energy companies. Revenues have been less positive, however; with fewer companies than usual beating expectations, analysts anticipate a third quarter in a row of declines.

Despite all of this, at the end of October, the technical trend for U.S. markets turned positive again, with indices moving back above their 200-day moving averages. These strong moves suggest that the breakdown in September may have been only temporary (as we have seen several times in the past couple of years).

Foreign markets also recovered last month, although to different degrees. Developed markets, as represented by the MSCI EAFE Index, showed the same kind of steady increase during October but stabilized toward month-end, posting a gain of 7.82 percent. The MSCI Emerging Markets Index also rose, though it declined on fears of a Fed rate increase from an almost 10-percent gain in the middle of the month to finish the period up 7.04 percent.

The strong performance in global markets was engendered by an easing of investor risk fears and continued central bank stimulus in Europe and China. Although European growth remains slow, the European Central Bank has committed to increased stimulus later this year, and the Chinese government announced its own round of stimulative measures.

Emerging markets also benefited from an improved economic picture in China. Technically, however, both the EAFE and emerging market indices remained below their 200-day moving averages, suggesting possible future weakness.

Fixed income markets had a challenging October, as decreased investor fears and a late-month statement from the Fed that many took as hawkish combined to drive interest rates higher. The 10-year Treasury yield increased from 2.05 percent at the beginning of October to 2.16 percent by month-end. Much of this change was in the last three days of the period, as the 10-year yield was at 2.05 percent on October 27, the day before the Fed announcement. The Barclays Capital Aggregate Bond Index returned 0.02 percent for the month.

U.S. economic recovery slows down
In contrast to the market's strong performance, the U.S. economy continued to slow. The employment report disappointed for the second month in a row, with gains of 142,000 jobs and a significant downward revision to September's number. Wage growth was equally disappointing—flat for the month—and average hours worked per week declined. The number of layoffs reported remained very low but still signaled a slowdown. Perhaps led by the weak employment numbers, personal income and spending came in below expectations.

From a sector standpoint, manufacturing and energy were the two areas of significant weakness. Manufacturing in general has an export orientation and has been slowed by both the strong dollar and slower growth in the rest of the world. The energy sector, with oil prices remaining low, has continued to shed workers and decrease investment in new facilities. Reflecting this situation, economic reports such as industrial production and durable goods sales have come in below expectations.
Despite the weakness in these sectors, there was some good news. The services sector was very strong, as indicated by the ISM Nonmanufacturing: NMI Composite Index number, and has remained near record-high levels following the financial crisis (see Figure 1). Because services represent seven-eighths of the U.S. economy, this is significant. In addition, consumer confidence either increased or remained at healthy levels, depending on the survey, suggesting that, although spending growth may have stalled, fundamentals are sound. Finally, housing continued to do well, with the housing industry survey at record levels and both housing starts and existing home sales beating expectations.

Figure 1. ISM Nonmanufacturing: NMI Composite Index, 2005–2015

The weakness of the energy and manufacturing sectors, combined with the slowing in consumer spending, contributed to the anemic 1.5-percent gross domestic product (GDP) growth rate for the third quarter, released late in the month. This was down from the previous quarter's growth of 3.9 percent, though in line with expectations. Even with this weak number, however, looking under the hood suggests that things are better than they appear. The decline was due to a substantial decrease in business inventory accumulation, which had rocketed the previous two quarters. Adjusted for that, the GDP decrease appears more reasonable—and less concerning.

Federal Reserve steps back into action
The basic health of the economy was ratified by the Fed in its regular meeting statement at October's end, as the Federal Open Market Committee expressed more confidence in the U.S. economy than it had in September and indicated that it could raise rates in December. After the surprise decision in September not to raise rates, this vote of confidence signaled that the Fed did not consider recent weak data to be significant. For the first time in years, the prospect of a rate increase was greeted by a market rally instead of a sell-off—a very positive development.

When the Fed raises rates, two things happen to stocks. First, the present value of earnings, discounted by the increasing interest rate, decreases. In a market dominated by interest rate factors, a rate rise means a market decline. The second thing that an interest rate increase can signal, however, is a faster-growing economy, which means faster sales and faster earnings growth. In a market that trades on earnings rather than interest rates, rate increases should, up to a point, signal a better market (in addition to price increases). The rally on the Fed's announcement seems to suggest that U.S. markets are starting to trade on fundamentals rather than interest rates—and that, too, is a very positive sign.

Halloween treats, not tricks
October has historically been a volatile month, but this year we got a powerful move up rather than down. Despite the worries as we entered the month—and the run of tepid U.S. data during it—markets responded to the better-than-expected corporate results and gradual economic improvement in the rest of the world.

Markets are inherently risky, so the strong gains in October, after the declines in the third quarter, should remind us that we won't always be so lucky. Risks remain around the globe, and the beneficial trends from which we now benefit won't always be there. It is important to stay focused on the long term and maintain a diversified portfolio that can ride out any turbulence in the short and medium terms.

The continuing U.S. recovery has laid the foundation for continued profits for U.S. businesses, and economic growth has historically tended to lead to higher market valuations. This confluence of positive factors suggests that future results, in the long run, should be positive for investors and that a long-term perspective continues to be the correct one.

Authored by Brad McMillan, senior vice president, chief investment officer at Commonwealth Financial Network.

All information according to Bloomberg, unless stated otherwise.

Disclosure: Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets. All indices are unmanaged and investors cannot invest directly into an index. The Dow Jones Industrial Average is a price-weighted average of 30 actively traded blue-chip stocks. The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. The Nasdaq Composite Index measures the performance of all issues listed in the Nasdaq Stock Market, except for rights, warrants, units, and convertible debentures. The MSCI EAFE Index is a float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI Emerging Markets Index is a market capitalization-weighted index composed of companies representative of the market structure of 26 emerging market countries in Europe, Latin America, and the Pacific Basin. It excludes closed markets and those shares in otherwise free markets that are not purchasable by foreigners. The Barclays Capital Aggregate Bond Index is an unmanaged market value-weighted index representing securities that are SEC-registered, taxable, and dollar-denominated. It covers the U.S. investment-grade fixed-rate bond market, with index components for a combination of the Barclays Capital government and corporate securities, mortgage-backed pass-through securities, and asset-backed securities.