Executive Summary

The U.S. Continues to Be a Bright Spot: Over the last three and five year periods, international stocks have been disappointing laggards compared to their U.S. equity counterparts. The third quarter was no exception.

Risk-off in High Yields: Volatility in the credit markets during the third quarter resulted in quality outperforming and credit suffering losses. High yields declined for the first time in five quarters.

Interest Rates Remain Low: Global rates remain very low, even negative across many European markets’ short term bonds markets. This has helped buoy U.S. treasuries and strengthen the dollar.


The global markets put in a sloppy performance during the third quarter as economic growth concerns and geopolitical events weighed on stocks and buoyed government bonds. The bright spot in the global economy is the U.S. as Europe flirts with outright recession and the Japanese economy has contracted in two out of the past three quarters. U.S. growth appears to be accelerating as the year progresses. First quarter growth contracted 2.1%, much of it explained away as weather related, while second quarter economic activity surged 4.6%. Labor market conditions remain solid as the economy has averaged 220,000 new jobs per month so far in 2014 and the unemployment rate dropped to 5.9% in September, a six-year low. All told, third quarter GDP is tracking near 3.5%, a respectable pace after 4.6% growth in the second quarter.*

The widening growth disparity between the U.S. and the rest of the developed world resulted in quite a bit of dispersion in global market performance during the third quarter as assets flowed into the U.S. For example, for the quarter the S&P 500 gained 1.13%. The MSCI All Country World Index lost 2.16%, the MSCI All Country World ex-U.S. declined 5.27%, MSCI EAFE lost 5.88%, and the MSCI Emerging Markets index lost 3.49%. Even in the U.S. there was a large performance gap with a quality bias as leadership narrowed. Small cap stocks were particularly hard hit with the Russell 2000 Index down 7.36% for the quarter.

The U.S. and Europe are now following different road maps with the U.S. Federal Reserve scheduled to cease their bond buying program in October while the European ECB is trying to stimulate a stagnating economy. In the U.S., the debate has turned to when the Federal Reserve will hike overnight interest rates. A growing consensus among economists is that the FOMC will begin to raise the fed funds rate sometime in the latter half of 2015. Historically, the Federal Reserve has begun hiking rates about twelve months following the end of an easing campaign. However, given the current growth trajectory of the U.S. economy, the rate hike could come sooner and we expect it to happen possibly as early as March 2015, and probably June 2015 at the latest. Even if the FOMC has the urgency to pull the trigger before mid-2015, we believe the earlier schedule would be largely immaterial to the economic environment.

Interest rates have remained very low globally. Short-term rates across many European markets did the unthinkable, with two year rates going negative during the quarter in many countries. Even European 10-year rates have plunged as Europe’s economy falters. German and French 10-year rates hit record lows and all of major Europe, and even the peripheral European counties of Spain and Italy, have lower 10-year rates than U.S. Treasuries. Treasury bonds remain buoyed by growth concerns in Europe and demand for U.S. bonds abroad, resulting in U.S. dollar strength. The trade weighted U.S. dollar has risen for 12 straight weeks and was up 7.72% for the quarter. The rising dollar makes U.S. based investments more attractive to foreign investors.

There was a lot of volatility in the credit markets during the third quarter with quality outperforming and credit suffering losses. For the quarter, the Barclays 7-10 Year Treasury index gained 0.47%, the Barclays Aggregate Bond index gained just 0.17%, and the Barclays High Yield index lost 1.87%. High yield bonds have performed very well over the past several years and the decline was the first quarterly loss in five quarters. In fact, it was only the second quarterly loss in three years. Credit spreads remain very tight historically and longer-term credit fundamentals remain well supported with a friendly Fed and a strengthening economy. There was a risk-off environment for high yield bonds as retail investors fled on the first hint of weakness, resulting in record outflows from high yield mutual funds and ETFs. However, so far institutions proved willing to buy high yield bonds as retail investors fled.

Q3 Portfolio Analysis & Performance

U.S. Style Opportunity
Top Contributors

  • iShares S&P 100 Index
  • iShares S&P 500 Growth

Top Detractors

  • iShares Russell Midcap Value
  • PowerShares S&P 500 High Beta

It is a difficult, nearly impossible task to keep up with the S&P 500 when a narrow concentration of gains among exclusively large cap stocks takes over markets. While the S&P 500 gained 1.1% during the third quarter, the S&P 400 Mid Cap Index fell 4.0%, and the Russell 2000 fell 7.4%. One had to have an exclusively large cap orientation to avoid losses, and by the second half of the third quarter the Style Opportunity portfolio was indeed 100% allocated toward large caps, as it remains today. Large Cap Growth (IVW) and the mega-cap S&P 100 (OEF) make up the majority of the portfolio, with the remainder in the S&P 500 High Beta ETF (SPHB). The first three quarters of 2014 have been dominated by large caps. While the S&P 500 is up 8.3%, the small cap Russell 2000 is down 4.4%. The 1200 basis points gap between large and small caps has at least put an end to frothy small cap valuations relative to large caps. However, small cap valuations remain high in the absolute, as do all U.S. equity valuations. With valuations making U.S. equities higher risk overall, we may still be facing further small cap underperformance in the coming weeks. In the longer run, we are awaiting a chance to re-enter small caps, as we believe their higher beta provides an excellent chance to add alpha over time. However, small cap relative strength remains only a distant vision in our relative strength rankings at this point.

U.S. Sector Opportunity

Top Contributors

  • iShares NASDAQ Biotechnology
  • PowerShares QQQ

Top Detractors

  • S&P Oil & Gas Exploration & Production SPDR
  • First Trust ISE Revere Natural Gas ETF

Among broad market indexes both here in the U.S. and abroad, the S&P 500 has been very difficult to beat. To a remarkable extent, this has also been true within the domestic U.S. Sector ETF sphere. The S&P 500 Index itself ranks extremely high in our Sector ETF ranks, so much so that we have a 20% position in the Index itself. Only two broad sectors, Technology and Health Care, rank higher than the S&P 500. A concentrated, narrow market this has been, indeed. Selected allocations to Transportation (IYT) and, recently, Financials (XLF) have been the only other bright spots that we could find. Most of the other broad equity sectors are weak and underperforming, including Industrials, Materials, Consumer Discretionary, Energy, and Utilities. Technology and Health Care appear to be unaffected by the slow growth world that we have entered, as their persistent leadership in relative strength can attest. Biotechnology (IBB) and the NASDAQ 100 (QQQ) were the portfolio’s biggest contributors while Oil & Gas Exploration (XOP) and Natural Gas (FCG) were the biggest detractors.

International Opportunity (Developed, Emerging & Frontier)

Top Contributors

  • iShares MSCI Thailand
  • iShares MSCI Frontier 100

Top Detractors

  • Market Vectors India Small Cap ETF
  • iShares MSCI Turkey

Finance theory states that international equities provide valuable diversification for a U.S. equity investor. However, over the last three and five year periods, international stocks have been disappointing laggards. Over a three year period (through 09/30), the S&P 500 (SPY) has gained 22.8% per year, while the developed markets EAFE (EFA) is up 14.0% and Emerging Markets (EEM) has gained 7.8%. Over 5 years, the S&P 500 has gained 15.0% per year, while EAFE is up only 6.5% and Emerging Markets has gained 3.2%. The best thing that a U.S. based investor could have done over the past number of years was to just avoid international markets entirely. We cannot do that in the International Opportunity portfolio, of course. However, we do include the U.S. as a country for purchase. Not surprisingly, U.S. equities rank higher than almost all other nations, and as a result we have allocated 20% to the S&P 500 (SPY). The powerful deflationary forces that haunt Europe and commodity-oriented nations have led to stock market and particularly, currency weakness. Extremely poor relative strength has pointed us away from these areas. The current portfolio includes a number of smaller, selected countries that have displayed relative strength versus the rest of the world, including Taiwan (EWT), the Philippines (EPHE), Canada (EWC), and India (EPI). China’s strong economy and stable currency have also led us towards a broad China ETF (GXC). Thailand (THD) and the Frontier Markets (FM), two markets not particularly correlated to the global economy, were the portfolio’s top contributors; India Small-Cap (SCIF) and Turkey (TUR) were the portfolio’s largest detractors.


The global markets have been in correction mode since peaking in early July. The stronger markets have gone sideways while weaker markets have experienced mid-single digit declines. This year has been an atypical mid-term election year as the markets haven’t experienced as much volatility as is historically normal in a mid-term year. For example, the U.S. has only had one correction of greater than 5% and three other declines in the 3% range. That is mild compared to other mid-term election years in recent memory. Now we are entering into the most favorable seasonal period of the 16 quarters in the Presidential Cycle. The fourth quarter of the mid-term year is the strongest of the 16 quarters, with the S&P 500 averaging a 7.5% gain since 1941. The catalyst to kick off this seasonal strength is the midterm elections, November 4th this year. Since 1982, the 30 calendar days leading into the midterm elections have all been positive. Over a longer-term horizon, the next four quarters are also the strongest four quarters historically of the 16 in the Presidential Election Cycle.

Based on the strength of the U.S. economy and macroeconomic research, U.S. interest rates could justifiably be 100 basis points higher than they are today. Evidently they have been held lower by a number of factors including foreign inflows, the low rates globally, Federal Reserve bond buying program, and geopolitical turmoil. The U.S. economy is certainly doing well enough to suggest higher interest rates lie ahead. With quantitative easing ending in the U.S. this month and the U.S. Federal Reserve preparing investors for a higher federal funds rate in 2015, the stage is set for U.S. interest rates to move higher. That seems to be the consensus call, so we will be alert to what may be wrong about that scenario as we move forward.

We know the Fed is preparing the market for higher interest rates. Higher rates have not been a major detriment to the market in the past, at least initially. The S&P 500 has posted strong gains the year before tightening cycles have begun, rising a median of 16.3% versus the long-term average of 8%. After the initial hike, the market has continued to rise but at a slower 5% median gain one year after the first hike. So, even in the face of higher rates in 2015, we look for the market to post continued gains.

*Source: Bloomberg; Renaissance Macro Research.

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The Dow Jones Industrial Average is a stock market index that shows how 30 large publicly owned companies based in the U.S. have traded during a standard trading session in the stock market.

The MSCI EAFE Index is a free float-adjusted market capitalization index that is designed to measure the equity market performers of developed markets outside the U.S. and Canada.

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