The stock market keeps chugging along. Despite all the notable headwinds: sovereign debt crisis in Europe, Fiscal Cliff here at home, hard economic landing in China, severe recession in Europe and a slowing domestic economy, the global equity market has managed to advance 13.4% year-to-date and the domestic market, as measured by the S&P 500, has increased 16.4%. A year ago the market was concerned about pretty much this same list of headwinds—since then the global equity market is up nearly 22% and the S&P 500 is up over 30%. The strategists appearing on CNBC and Bloomberg would describe this phenomenon as the market climbing a “wall of worry”. The markets’ ability to climb a wall of worry reflects investor confidence that these issues will be resolved, presumably favorably, at some point. We have no doubt these worries will eventually be resolved; we aren’t sure that they will all be resolved favorably; but, we are pleased with what the markets have given us these past twelve months.
The European Central Bank’s announcement that it would buy sovereign debt in the open market, with the circumspect approval of the Germans, reignited the market rally. This move essentially replicates our own Federal Reserve Bank’s first round of quantitative easing. Not to be outdone, the Fed announced after its September Federal Open Market Committee meeting another round of quantitative easing as well. In keeping with the normal numbering sequence this would be QE3, but given the indefinite time horizon and unlimited size of this round of quantitative easing we have dubbed it “QE Perpetuity”. With the major central banks providing the stimulus, the “risk on” trade was back and most markets saw meaningful advances in the third quarter. Domestic small-cap stocks were up 5.3%, large-cap stocks were up 6.3%, developed international stocks were up 6.9% and emerging market stocks were up 7.7%. Commodities were up 11.5%; and, even bonds, which typically move in the opposite direction of stocks, had a strong quarter with domestic investment grade corporate bonds up 3.4%, high yield bonds up 4.4% and European sovereign bonds up 5.1%.
While we began the quarter with a more cautious posture than we’ve had in the past few years, our clients’ portfolios still participated pretty fully in the market rally. Much of this was due to our core allocation to real assets, specifically precious metals, natural resources, energy infrastructure and commercial REITs. As a group, our real asset holdings were up 12.8% for the quarter. These investments are much more defensive than the overall stock market but they tend to outperform stocks, as they did this past quarter, in periods in which inflation expectations are on the rise and/or the dollar index is in decline. Longer-term inflation expectations increased 0.5% and the dollar index declined 3% during the quarter.
We became much more constructive toward the market with the announcement of QE Perpetuity and have since reallocated much of the cash we were holding. The Fed is basically abandoning its dual mandate of controlling inflation and supporting growth and replacing it with a single mandate to support growth. The European Central Bank is trying to do the same; and, we expect the Chinese central bank won’t be far behind. The clear near-term beneficiaries of an “inflation be damned, we need growth” policy are risk assets such as stocks, commodities, real assets and certain high yield debt instruments. There are still a number of speed bumps between now and the end of the year which will test the market’s resolve to continue climbing this wall of worry; but, we believe the trajectory remains pointed higher. Not to worry, while we want to make sure our clients’ portfolios continue to participate in any further moves up, we remain committed to our mandate to build the least risky portfolios necessary to achieve our clients’ financial goals.