September lived up to its reputation as historically the most troublesome month for stocks. The S&P 500 finished the month with a loss of 1.4% to narrow the quarterly gain to only 1.13%. However, the carnage was mostly directed at smaller market capitalization stocks. The Russell 2000 of smaller company stocks was down 7.36% for the third quarter of 2014 and is now down for the year at -4.41%, in contrast to the 8.34% gain for S&P 500.
October will mark the end of the current round of quantitative easing by the Federal Reserve. In this regard, we are experiencing a monetary policy without precedents, hence the guidance of history. Yet in a liquidity driven market, the effect of central bankers are the critical factor that investors must understand. Traditionally, equity market would begin a correction process only after interest hikes that have produced a restraining monetary policy. In this new world of quantitative easing, can the cessation of stimulus count as a form of restrain? Much can we speculate, but we have yet an answer.
While US monetary authority is on a path to end monetary stimulus, their counter parts in Europe and Japan are revving up their easing policy in earnest. This is evident by the extremely low interest rate paid on government bonds across continental Europe and even lower interest rate across the Pacific. So while the US monetary policy may no longer be stimulating, the global monetary backdrop remains constructive.
The differing policy stands between US and Europe is due to the stronger economic footing of the US economy. Indeed, consumer confidence shows a rising trend, leading indicators are supportive of sustainable growth, employment conditions are improving, manufacturing is experiencing a renaissance and capital spending are kicking into high gear.
The mild correction that occurred to stocks during the second half of September may be discomforting for investors who by now are used to steadily rising markets. With the Fed ending its quantitative easing policy, it would serve investors well to be prepared for greater volatility. We believe markets will behave more supportively as the earnings season starts in the second half of October. This belief is based on supportive global monetary policy and low interest rate globally. This low interest rate environment lends support for stock valuation. In addition, we are constructive on corporate earnings given an improving US economy.
Dong Hao Zhang
President & Chief Investment Officer Evla Hills Investment Management