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3rd Quarter 2016


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The Standard & Poor's 500 returned 3.9% in the third quarter, following a 2.5% total return in the second quarter.

Prices for a share in America's largest companies rose amid a stream of positive reports on personal income and spending, retail sales, employment, job openings, and the leading economic indicators (LEI).

Meanwhile, after a yearlong recession in earnings, a recovery in earnings on blue-chip U.S. companies is forecast for the two quarters immediately ahead by Standard & Poor's, and dormant inflation gives policymakers leeway to keep credit loose, to stimulate the slow-but-sustainable growth pace of one of the longest economic expansions of the last century. 

 

 


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Examining the performance of the U.S. stock indexes by their market capitalization and valuation reveals a significant gap in the returns on large versus small-cap companies.  Ensuring your portfolio is properly diversified begins with an analysis like this. This chart shows why rebalancing a portfolio is rational, and how it keeps you from becoming too heavily invested in any one or two asset classes that lead performance. 

 


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The technology sector stands out in this chart of the performance of the 10 Standard & Poor's industry indexes in the quarter.

Following 18 months of going sideways, the S&P 500 rewarded risky tech stocks almost threefold over the 4.6% return of the runner-up financial companies. Who could have predicted that? No one. Which is why strategically managing a portfolio is important.

Shares in industrial and materials companies rallied in the third quarter. Investors liked bid-up prices amid a steady drip of positive economic data. Not surprisingly, defensive and interest rate sensitive – telecom services and utilities – lagged.

 


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In the three months ended September 30, 2016, China, Emerging Markets, Asia Pacific, and the Eurozone all outperformed the U.S. stock market. It was the third consecutive quarter in which U.S. stocks lagged. It's not a bad thing. The U.S. stock market is up and global markets are catching up after lagging the U.S. for years.

Large publicly held U.S. companies were the leaders among world regional stock indexes quarter after quarter since the U.S. economic trough of December 2007 and the global financial crisis it precipitated. The global expansion, a source of consternation earlier in the year, is showing new signs of growth, and sentiment improved globally.

 

 


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In the quarter ended September 30, 2016, the global stock market index that excludes U.S. stocks rallied 7.2%. Global economic data eased fears of a global slowdown.

No. 3 on the list of best-performing assets was the S&P 500. Major metrics of the U.S. economy are good. With inflation dormant, the Fed reaffirmed the likelihood of low rates for the foreseeable future.

Meanwhile, high-yield bonds and leveraged loans rallied. Risky investments were in style. 

MLPs continued their recovery following last year's wipeout after the plunge in crude oil prices.

Crude oil and commodities slumped following their dramatic upside reversals last quarter.

The twists and returns documented here are unpredictable. A strategic, systematic investment discipline is the best solution.

 

 


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In the yearlong period through the end of September 2016, stocks showed a strong 15.4% total return -- about 50% more than stocks historically have returned during an average year. It's been an uneven, unpredictable, and unlikely path to this extremely strong 12-month result.

A year ago, profits had collapsed in the energy and mining sectors. Earnings on the entire S&P 500 index were dragged down by the terrible times that hit energy businesses in the U.S. However, those 12 terrible months dropped out of the trailing 12-month earnings equation. Earnings snapped back, carrying prices higher.

The most volatile moment was a 12% plunge in the S&P 500 in February over fears of a global slowdown. Oil prices sank below $30 per barrel and the China slowdown sent jittery investors to the sidelines. Fear abated by the end of the first quarter of 2016, however, and global economic data firmed. Moreover, the drumbeat of good reports came monthly on new jobs, declining unemployment, and rising real personal income and spending. The rat-tat-tat of good news hit every month throughout the year. 

Britain's stunning vote to exit the European Union hit U.S. stocks June 24. Initially, the Brexit selloff erased more than 5% of value from the S&P 500, but the loss did not last long. Stocks recovered by the end of the quarter and the bullish sentiment that dominated in July, moved a bit higher in August, and drifted sideways in September.

 


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Having been the one-year laggard a quarter earlier, Small-cap Value companies rallied to become the third quarter's performance leader among asset categories of different sizes and styles. 

This is yet another illustration of how performance routinely rotates among investment styles and market capitalization. These characteristics, when used to distinguish among types of liquid U.S. equity investments, create a basis for systematic analysis of a personal portfolio. It's not rocket science. It's investing systematically, applying a discipline, and checking it annually, at least, to ensure it's working the way it's intended.

 


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Faced with record-low bond yields, investors sought out dividend yield in the 12 months ended September 30, 2016. Telecom services was the No. 1 sector, with a 26.8% gain. 

The technology sector surged, too, as risky investments were rewarded in this one-year period. Meanwhile, in reaction to a flow of positive economic data month after month, industrials and materials stocks rose strongly.

Financial companies were in last place, with ultralow interest rates making it more difficult for banks to earn a spread on their loans.

 


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For the 12 months ended September 30, 2016, non-U.S. regional stock markets -- excluding Europe -- outperformed the S&P 500 for the first time since last year. Global economic growth remained positive and fears of global recession faded further into the distance.


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REITs, both U.S. and global, scored the best returns in the year ended September 30, 2016, as investors sought dividend yields to replace record-low bond yields.

In a reversal of a five-year slide, this index of gold futures contracts rose by 17% over the year, but natural resource-related assets otherwise were laggards and were among the worst one-year performers. Despite the rally off a February 2016 bottom, crude oil posted terrible losses, as did commodities.

 


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The third quarter's small-cap surge put small-caps back in first place over the trailing five-year period. The S&P 500 large-caps had been leading the five-year return rankings for many quarters.

Small-caps' return to leadership reflects investors' improved confidence in the economic outlook and a return to rewarding riskier assets. Once fears of a global economic slowdown subsided, the more volatile assets reacted as would be expected by surging the most.

 


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Consumer discretionary, health care, and technology were the three best-performing sectors in the five years ended September 30, 2016, as shares in companies classified as “growth” investments led the pack.

Conversely, the lagging sectors -- energy, utilities, telecom services, and materials -- consist mainly of stocks that are classified as value investments.

The energy and material sectors were slammed by the collapse in crude oil and most other commodity prices.

 


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For the five years ended September 30, 2016, the U.S. indexes -- small-, mid- and large-cap -- outperformed major bourses across the globe.

Notably, small- and midcaps led the large-cap S&P 500 index. With small-caps and midcaps outperforming returns on the largest U.S. companies, U.S. equity assets have returned to the classic long-term risk-reward relationship of the postwar era.  To be clear, small- and midcaps are expected to provide the strongest returns because they are more volatile than large-caps. That long-term rubric has not been evident in years, but is in this five-year snapshot.

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For the five years ended September 30, 2016, the large-cap stock index and REITs, both U.S. and global, were the top performers. 

The S&P 500 index's total return of 113% over the past five years is more than double the return garnered by the 41% return on the S&P Global index excluding U.S. stocks. This chart shows the resilience demonstrated by the U.S. economy after the severe global recession compared to the rest of the world's economies.

In last place, over this five-year period, was crude oil. Commodities and gold have been money-losers over the past five years due to the strong dollar, slowing growth in demand for most commodities, and dwindling inflation.

 


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After trading sideways for approximately 18-months -- buffeted by three double-digit plunges -- the stock market settled into a slightly higher range in the third quarter of 2016.

For the five years ended September 30, the S&P 500 total return was an incredible 113%, a doubling of your money. Without reinvest dividends, the S&P 500 gained 92% in the period.

 


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This expansion started in July 2009. At 88 months, it is the third longest expansion since 1854, according to the National Bureau of Economic Research (NBER).

In the last century, America experienced 19 economic cycles, according to NBER; 12 economic cycles occurred since 1945.

The three U.S. expansions that have lasted longer than the one we are in currently all occurred since 1961 as shown above. 

The likelihood of a bear market -- a correction of at least 20% -- increases as the bull market grows older. 

However, as the fourth quarter of 2016 began, fundamental economic conditions that have accompanied bear markets in the past were not present: Restrictive Fed policy, the likelihood of slowing economic growth, stock market overvaluation, and irrational exuberance -- historically important precursors of a major market downturn -- were not evident. In fact, this economy has been rolling along.

 


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While the strong and long economic expansion may seem undeniable, many people do not seem to notice it. Although the fundamental drivers of U.S. economic performance are all positive, according to a range of objective metrics, tunnel vision frames the public discourse and has fueled the now-widespread belief that the economy is weak and that Americans are in bad financial shape.


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Why is the economy widely believed to be in crisis when really it's doing just fine?

One theory is that the human brain is hard-wired to think that recent events influence the future more than they really do.

 


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Systematic cognitive biases in the way humans think were documented in 1973 by the late Amos Tversky and Daniel Kahneman. Kahneman was awarded the 2002 Nobel Prize in Economics for this groundbreaking discovery.

A cognitive bias that tends to overweight the importance of dramatic recent events may explain why so many Americans think the economy is in crisis when objective metrics overwhelmingly show that the economy is doing just fine.

 


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Americans are still traumatized from the Great Recession, the worst financial crisis since 1929,which occurred in 2008.

Deep psychological wounds take time to heal and many people can't accept that the economy is good again.

 

 


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American political leaders have been of little help.

Politicians almost never say the economy is doing just fine. 

Their success depends on talking down the economy and talking up how they'll fix it. 

Being upbeat would alienate too many voters.

Their role is never to be satisfied.


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The news media also is culpable for contributing to the common misperceptions that the economy is in dire straits.

None of the strapping cable TV anchors knows enough to fact-check the so-called experts they interview.

For example, people commonly believe that Americans have not had a pay hike in 15 or 20 years. 

This untruth is repeated on all of the cable TV news outlets throughout the day without being challenged. 

But it is patently false.

 


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Cognitive biases, a failure of leadership, and a media that shows no appreciation for the math driving the economy: it's a perfect storm of factors complicating our understanding of what's true.

So here are the facts.


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We're experiencing the best economic expansion since the economic peak of 2006 and 2007.

Inflation is dormant and job openings are at a record high.

 


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The last such wondrous economic period was in 2007.

That was an asset bubble!

People were using their homes like ATM machines and went on buying sprees fueled by bad loans.

This economic expansion is different, however, and the strong economy is for real -- not the result of a debt-binge.

 


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Like the little train that could, the economy is rolling along at a slow, sustainable growth rate.

 


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Historically, economic downturns in the U.S. often were caused by the Federal Reserve's policy mistakes -- the Fed has tightened when it should have loosened credit, or vice versa. 

But because inflation has been so low, the Fed has room for error.

 


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We could list 20 recently released data points illustrating how smoothly the economy is running, but this one chart explodes the myth that Americans are in an economic downturn.

In 1980, 38% of American households were in the middle-income bracket versus just 32% now. 

Similarly, about 24% were classified as poor or near-poor in 1980 versus 17% recently.

That's really good news based on the most recent data available: The ranks of the upper-middle income have swollen.

Since 1980, the share of the population of Americans in the upper-middle income category nearly doubled, from 15 to 29 percent, and that's a key engine of growth of the consumer-driven American economy -- that's what makes America great.

Contrary to popular belief, more Americans are prospering and getting their fair share of The American Dream.

 


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The U.S. employment situation is as good as it's been since the peak of the economic expansion in 2007, wages are rising, inflation is dormant, and new orders at big businesses are surging.

It's a Goldilocks economy! Here are the numbers.

 


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Let's start our list of good economic news emerging with the surge in new orders in the non-manufacturing sector. 

The Institute of Supply Management (ISM), a trade association for purchasing managers, has tracked manufacturing orders for decades. 

In 2008, ISM began reporting results of a new monthly survey of its members in the non-manufacturing segment of the economy, which accounts for about 86% of U.S. gross domestic product. 

A reading greater than 50 indicates that the economy is expanding, and a persistent sub-50 reading indicates an oncoming recession. 

At 57.1, a recession is nowhere in sight.


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Another good sign was news that 156,000 new jobs were created in September.

Contrary to reports in the consumer press portraying an anemic jobs recovery, new-job formation in the past seven years has been typical of past economic expansions.

 


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Another sign of strength came from data on weekly unemployment claims.

The unemployment rate is now well below the previous low in the last economic boom.

 


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Yet another fresh sign of economic strength: average hourly earnings continued to accelerate in September.

The 2.6% growth in hourly earnings in the 12 months ended September 30 is much higher than the 2.1% compound annual growth rate averaged since the end of the Great Recession.

 


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In addition, adjusted for inflation, real average hourly earnings -- Americans' real purchasing power -- recently topped its all-time high.

While the news is filled with talk of American workers not getting a pay hike in 15 years, it is simply fiction. Look at that surge!

 


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This next statistic is crucial. Consumer income drives consumer spending. Consumer income is the red line in this chart, consumer spending is the black line, which accounts for 70% of the US economy.

What you're looking at in this chart is a very healthy year-over-year gain of 3.4% in the compound annual growth rate of personal disposable income, and this key driver of the US economy is poised to continue growing. 

The savings rate, at 5.3%, has very substantially recovered from the pre-recession lows. Americans have improved their spending behavior and reloaded their checking accounts, ensuring support for continued consumer activity.



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Inflation is substantially lower today than it was prior to the last recession. So if you adjust real disposable personal income for inflation, you get this measure called Real Disposable Personal Income.

Real spending power on the part of American families is growing at a record high rate of 3.4% year-over-year compared to the five-year average prior to the last recession of just 2.8%. 

Income stagnation is fiction.


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How about household balance sheets? Household net worth has fully recovered and we're at record all-time highs on household net worth, suggesting that the wealth affect should be operating in a positive direction today.

 


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With respect to the U.S. household's ability to spend money, the Financial Obligations Ratio is the acid test. It is a statistic compiled by the Federal Reserve and it shows the percentage of the average household's monthly after-tax income needed to cover all fixed recurring monthly obligations -- the American household's monthly nut. 

It's the mortgage payment, car payment, credit card payment, real estate taxes, utility bills, and so forth.  It is at a record low, with just 15.3% of the average household's income needed to cover monthly fixed expenses.

With 85% of the average household's after-tax income available for all other discretionary spending, strong consumer spending growth could remain the trend for the foreseeable future.

 


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You also hear talk about a record number of people in poverty. This is a commonly cited statistic and is commonly distorted. The number of those in poverty increases with the population, which politicians on both sides of the aisle often fail to mention.

The important statistic is the poverty rate: the number of people defined to be in poverty compared to the total population. 

After every recession, the poverty rate peaks. We're now back down to a rate that in line with history.

By the way, look at how today's poverty rate compares to the levels that we saw back in the '60s and '70s. Talk about a vast improvement in the poverty situation of the United States. That's what we see here.


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With fresh evidence of strength in jobs, new orders, and earnings -- and inflation not a threat -- the economy is not too hot or too cold; it's just right.

For now, it's a Goldilocks economy.



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2nd Quarter 2016
1st Quarter 2016
4th Quarter 2015
3rd Quarter 2015
2nd Quarter 2015

This article was written by a professional financial journalist for The Dover Group and is not intended as legal or investment advice.
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