Stocks fared poorly for the third quarter as markets in the U.S. and abroad stumbled badly in late August. Major U.S. equity indexes all logged significant losses for the quarter. Having made limited progress through the first half, the indexes are in the red for the year so far

through September. Markets abroad fared no better with some emerging markets such as China and countries that depend on exporting commodities such as Brazil and Indonesia getting hit especially hard. By sector, utilities offered the rare positive return, and the traditionally defensive consumer staples declined least. Markets had been stuck in a fairly tight trading range since January, unable to make a sustainable move up or down. Absent any positive catalysts, investors gave in to worries about China’s decelerating economic growth and how its impact on other emerging countries could spill over into a global recession. Please see the article on page 2 for more on China. That worry, coupled with persistently weak oil prices and a seemingly indecisive Fed, was enough to cause the market to fall out of bed. On a global scale, it is too soon to call for recession. The majority of economies including Europe, Japan, India and Mexico are still growing. Risk of recession in the U.S. remains low even though exports and manufacturing have hit a soft patch. Consumer spending has generally held up, and auto and home sales have been very strong lately. The latest employment report was downbeat showing a moderation in job growth trends, but, on balance, U.S. economic trends continue to be favorable. The sudden return of market volatility and the China growth scare caused the Federal Reserve to back away from a long-anticipated September interest rate hike. An initial hike in October or December remains a strong

possibility but will depend on how the Fed reads the economic tea leaves between now and then. Many think the Fed should go ahead with a token raise just to get it over with and give the market some clarity. However, after holding rates so low for so long, they are not likely to abandon their “data dependent” approach and do anything to risk sidetracking the recovery. In the coming weeks and months the market will tell its own story about what it is going to do. If seasonal and cyclical tendencies hold true, we should expect stocks to regroup and finish the year strongly. At least in the short term, a great deal of the complacency and excessive optimism in stocks has been corrected. We’ll need to watch any fourth quarter rally closely for clues about if and how the longer-term bull market trend may resume.

  Check out our updated website at www.dh .com October 2015

♦ Global stock markets fared poorly in 3rd quarter. ♦ The Fed is seemingly indecisive, but a rate hike in 

October or December may s ll be likely. ♦ Chinese economic growth is decelera ng. ♦ Many global economies s ll growing. 

Also in This Issue Page 2: Equi es in a Rising Interest Rate Environment. 

Pages 2 & 4: A Slowing China. Page 3: Power of Compound Returns. 

 

Market Measures  3rd Qtr. 

S & P 500 (price)  ‐6.9% 

Dow Jones Industrial Average   ‐7.6% 

NASDAQ Composite   ‐7.3% 

Russell 2000  ‐12.2% 

MSCI EAFE   ‐10.8% 

Barclays Capital Inter Gov’t/Credit Bond Index  

    9/30/15  9/30/14 

10‐Year U.S. Treasury Bond Yield    2.05%  2.50% 

Three‐month U.S. Treasury Bill Yield    0.01%  0.03% 

+0.9% 

YTD 

‐6.7% 

‐8.6% 

‐2.5% 

‐8.6% 

‐7.3% 

+1.8% 

I  O  

Third Quarter 2015 Review & Outlook by Whitney Brown

Page 2

Equities in a Rising Interest Rate Environment by Watt Dixon

The Federal Reserve’s benchmark interest rate, known as the Federal Funds rate, has been set at a record low of 0.25% since December 2008. It’s hard to imagine that it averaged 6% since 1971 and soared as high as 20% in

1980. The Federal Reserve is expected to raise interest rates eventually when it believes the U.S. economy can stand on its own without stimulus. Many investors believe that rising rates are bad for equity prices. In a rising rate environment, bonds become more attractive relative to stocks, and businesses must spend more to borrow money for capital expansion and other projects. While the Fed left rates alone at its September meeting, there is a strong likelihood that the Fed will bump rates upward soon. The housing and labor markets are both improving, which should prompt the Fed into action. Despite the belief of many investors, global equity prices have often rallied in both the run up to policy rate hike cycles and in the year following the onset of rate increases, with the health of the economy a key consideration. In the U.S. , large cap stocks have frequently staged a short term dip as investors assess the change in the environment, but these episodes have proven to be buying opportunities . However, more interesting is how different sectors of the broader stock market react in different economic environments. The S&P 500 is comprised of 10 economic sectors. Defensive sectors include Consumer Staples, Health Care, Utilities and Telecom Services. These sectors produce goods and services that people need or use regularly almost regardless of economic conditions. Changes in interest rates have only a subtle effect on the revenue and earnings of these sectors. Deep cyclical sectors include Energy, Information Technology, Industrials, and Materials. These sectors are sensitive to economic conditions. When economic times are good, the stocks within these sectors benefit from strong sales and earnings, with investors buying electronics and making major investments. Interest rate sensitive sectors include Consumer Discretionary and Financials . Low rates make it easier for consumers to make purchases, especially on big ticket items

like houses and vehicles. A financial stock’s profitability is very dependent on the interest rate environment. It is important to remember that stocks react by anticipating potential changes in the economy. The chart below illustrates the performance of all ten industry sectors over the last seven Fed credit tightening cycles. Notice the defensive sector underperformance while the deep cyclical sectors have outperformed. Financials show only modest underperformance.

Today’s interest rates are starting from significantly lower levels than the past seven Fed tightening cycles which may have less impact on the profitability of the financial sector. In conclusion, if the chart above is any indication of future stock prices in the next Fed tightening cycle, we could see a rebound in the Energy sector and continued appreciation in many technology stocks. Also, once interest rates have normalized, we could see financial stocks begin to perk up as well. This is a turbulent time for stock prices and now more than ever calls for a diversified stock portfolio and a balanced investment approach.

In the second quarter of 2015, our equities market turned its short-term focus to the Greek debt crisis and the fear that their problems might be transferred to the global economy. When that situation seemed to reach a satisfactory resolution in August, rather than celebrating, the market

immediately turned its focus to a perceived “slowdown’ in China and how their lack of growth will spell doom for our equities market. Almost overnight, we saw any company with exposure to

the Chinese market quickly sell off and turn 2015’s small gains into losses. Unfortunately, those declines from Chinese exposure bled over into the rest of the market and ended up bringing down the value of most companies without regard for their profitability. It seems this fear may be misplaced or overblown. Yes, it is true that Chinese GDP (Gross Domestic Product) growth has declined on a percentage basis (consistently growing at 10-12% annually in years past vs. only 5% this year). However, there are some mitigating circumstances that should be considered. When China’s GDP was increasing year after year at a

(Continued on page 4)

A Slowing China by Jim Hall

   Page 3 

A recent commentary from Ned Davis Research highlighted that compounding returns is a very powerful investment tool and the main key to accumulating wealth. Simply, compounding means reinvesting your investment returns each period along with your original investment, or earning returns

on your returns. From the chart below, you can see that the stock market as measured by the S&P 500 Total Return Index, compounded since 1926, has tripled the total return of the next best asset classes (corporate and treasury bonds). Stocks have returned 10% on average annually, which is almost double the next highest asset classes.

The classic case of compound returns goes back to the year 1626 when American Indians sold Manhattan Island to the Dutch. They were paid 60 guilders ($25 at today’s exchange rates). Had the American Indians invested their proceeds in a tax-deferred account using a mixture of stocks and bonds which has yielded approximately 7.9% annually since 1926 (for our example, we will use this annual compound percentage back to 1626) their $25 would be worth $175 trillion. That sum could purchase not just all the real estate in Manhattan but all the real

estate in the U.S. They even would have enough money left over to purchase all the stocks listed on the U.S. stock exchanges. The lesson of compounding returns not only applies to investors, but to also to debtors who get hit owing interest on interest. The U.S. Treasury is a large compound interest payer. During the 2014 fiscal year the U.S. paid interest on our debt of almost $448 billion. This represents 11% of total U.S. Government expenditures. These examples use constant annual gains to show the power of compounding. However, what happens when you have a negative annual return? If you make an investment of $100 and it declines to $50, you have a 50% loss, but to get back to even will require a positive 100% return. This illustrates Warren Buffett’s rules on making money: “Rule # 1 - Don’t lose money. Rule # 2 - Don’t forget Rule # 1.” Managing money is a business of making mistakes! The difference between a successful investor and an unsuccessful investor is the successful make small mistakes while the unsuccessful make big mistakes! Don’t let a small loss turn into a big one. From these examples you can see that compounding returns is one of the best ways to get rich. Also, compounding the interest on debt is a good way to go broke.

Power of Compound Returns by Stebbins Hubard

Monthly Data 12/31/1925 - 9/30/2015 (Log Scale)

(B437)

Gain/ AnnualizedInvestment Annum Std Dev

S&P 500 Total Return ( ) 9. 9% 19.1% Barclays Corporate Bond Tot Return# ( ) 5. 7% 5.9%Barclays Treasury Bond Return# ( ) 5. 6% 8.3%Gold Bullion ( ) 4. 5% 15.9% Treasury Bills Total Return ( ) 3. 6% 1.0%CPI * ( ) 2. 9% 1.7%

* Data Lags Chart by One Month# Ibbotson data prior to 1973

All I

ndex

es a

lloca

ted

to 1

00 o

n 12

/31/

1925

Source: S&P Dow Jones Indices 577393

118 151 192 245 313 399 509 649 827

1055134517152187278935564535578273739402

11989 15288 19494 24858 31697 40419 51540 65721 83803

106861136263173755221563282525360260459383

577393

118 151 192 245 313 399 509 649 827

1055134517152187278935564535578273739402

11989 15288 19494 24858 31697 40419 51540 65721 83803

106861136263173755221563282525360260459383

1930

1935

1940

1945

1950

1955

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

2015

Comparative Investment Returns Since 1926

Copyright 2015 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. . www.ndr.com/vendorinfo/ . For data vendor disclaimers refer to www.ndr.com/copyright.htmlSee NDR Disclaimer at

©

Concept and chart courtesy of Ned Davis Research.

Page 4

  

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A Slowing China (continued)

double-digit pace, they were growing from a smaller base (note the chart below which tracks China’s GDP translated into U.S. dollars: for example, $10.3B in 2015 vs. $5.1B in 2010). As long as GDP is increasing, perhaps we shouldn’t worry as much about the percentage rate of growth. Another factor that should be considered is the Chinese consumer. The population of China was roughly 1.4 billion in 2014 and is continuing to grow. Its citizens comprise roughly 20% of the global population. Instead of toiling on government-controlled farms in exchange for a small monthly stipend and some of the food they produce, a large number have embraced the idea of education, working for better wages, and buying things for themselves and their families. In 2010 the average annual income was $5,238. In 2015, their average annual income is $8,982. Increased income allows their citizens to become true consumers. Many citizens have purchased vehicles for the first time. They have also embraced the use of cell phones, and China continues to grow their coverage/service area

(Apple is expecting to continue gaining market share as China continues upgrading to LTE technology). Finally, speaking strictly from a U.S.-centric point of view, American companies’ exports to China accounted for less than 1% of our GDP in 2014. With that in mind, the recent 10%+ sell-off in our equities market seems to be a considerable over-reaction to possible softness in China. Hopefully, as third quarter corporate earnings begin to be released, good numbers will be reflected and ease some of the concern about “slowness” in China.

(Continued from page 2)

Source: www.tradingeconomics.com | World Bank Group

USD Billion