Investment Review for Third Quarter 2016

Most asset classes rose during the third quarter despite lackluster earnings results, anemic economic growth, and somewhat expensive domestic valuations. For many, traditional metrics used to value assets and make capital allocation decisions have been replaced by “TINA” or “There Is No Alternative.” With interest rates near zero (and likely to remain there for some time) in much of the developed world, many investors justify paying higher prices for stocks, real estate, and other risky assets because the alternative is accepting a zero return on safer assets.

Major asset class returns.

Earnings.

After five consecutive quarters of declining corporate profits, earnings for large U.S. companies rose during the second quarter. The earnings data, which was released over a three- month period from July to September, also showed corporate sales increased 1.2%. Third quarter results, which will be released over the next several weeks, continue to look promising based on the most recent analyst estimates compiled by Standard & Poor’s. However, these estimates, which currently project earnings growth of approximately 15%, have been cut in half since their first release in March of last year.

Stock valuations.

Domestic stocks have appreciated significantly over the past several years, which has led some to question their current valuations. With prices rising much faster than earnings, domestic stocks do indeed look a bit stretched when compared to historic measures. In contrast, foreign stock valuations are more attractive and may prove to be rewarding for patient investors over the next several years.

ZIRP and NIRP.

Over the past several years, ZIRP (Zero Interest Rate Policy) and NIRP (Negative Interest Rate Policy) have had a distorting effect on financial markets. The phenomenon has eliminated the need to be careful with capital and use it wisely. As such, governments have been permitted to borrow increasingly large sums of money at low to no costs; financing additional deficit spending at the expense of implementing much needed structural reforms.

The heavily manipulated interest rate environment has confused and obscured the efficient allocation of capital in the private sector as well. Corporations have gone on spending sprees buying back shares of their own stock, as well as buying competitors through mergers and acquisitions. While these moves may temporarily appease investors, they do not fuel innovation, help develop new products, increase productivity, or benefit the real economy.

Bond yields and risks.

Central bank activities have depressed interest rates to a point where returns on core bonds are low or nonexistent. With no guarantee that the current low interest rate environment will persist, many core bonds (which have historically been characterized as safer assets) now possess a risk of serious loss if a sharp rise in interest rates should occur.

The first presidential debate.

The 2016 presidential race has offered plenty of surprises, from the nomination of a political outsider / businessman / reality TV star by Republicans to the near success of a self-proclaimed socialist in the Democratic primary. As the polls swing from one candidate to the next, the financial markets continue to ebb and flow as traders and investors attempt to interpret what this means for the economy and financial markets. While nothing is for sure, it is likely that both political uncertainty and financial market volatility will increase as we approach Election Day.

Domestic economic growth.

Through the first six months of the year, the economy expanded at a lackluster 1.1% annualized rate. While still positive, the rate of growth is well below the 2%+ growth rates we realized over the past few years and far below the 3% growth most would like to see. A portion of the sluggishness can be attributed to changes in inventory levels, which have subtracted 0.8% from GDP thus far in 2016. Fortunately, this trend is unlikely to continue for an extended period of time.