The third quarter saw disappointing market movements. In fact, it was the worst quarter in 4 years[1]. For some, it brought back painful memories of 2008, but it more closely resembled the summer of 2011. There was a large sell-off in stock markets around the world, while bonds rallied. Large cap U.S. stocks fared better than their smaller counterparts. Large cap U.S. stocks were down 6.44% for the quarter, while small cap U.S. stocks were down 11.92%[2]. Foreign stocks also posted negative returns of 10.23% for the quarter[3]. Commodity prices dropped considerably due to weakening foreign markets, most notably China and a very strong U.S. dollar. Given what occurred in stock markets around the world, bonds performed as we would expect by producing positive returns. Bond indexes were positive for the quarter, ranging from 1.23% for the U.S. Aggregate Bond Index to 1.71% for the World Government Bond Index[4].

In our previous quarterly letter, we wrote about concerns related to China’s economic slowdown and Federal Reserve policy. Both of these concerns dominated the headlines during the quarter, and were generally considered two of the main catalysts for the market decline. Although we had concerns, and still do, we believe the market pulled back more than what was justifiable. Fear and uncertainty overwhelmed investors, while the markets discounted any good news, such as continued increase in consumer confidence, consumer spending, and personal income.

Due to globalization, it is essential to understand the interrelationship between economies throughout the world. It’s hard to believe the world’s second largest economy can be an enigma, but that is the case with China. Due to market manipulation by the government and a lack of free markets, it is difficult to trust and understand economic data related to China. In August, China shocked markets by devaluing its currency. This manipulation was an attempt to boost their economy by aiding exportation of Chinese goods. A devalued currency makes Chinese goods less expensive for foreign consumers.

The most notable headline during the quarter was the Sept. 17 Federal Reserve meeting. During the first half of the year, the consensus was the Federal Reserve (Fed) would raise short-term interest rates for the first time since June 2006. The Fed elected not to make a change to interest rates due to the slowing Chinese economy and devaluation of its currency, along with slumping oil prices lower than expected, job figures and general concern over global economic weakness. There was an immediate negative reaction to this, as noted by the sell-off in global stock markets. The concern was whether the U.S. economy was weaker than expected, or if the inactivity by the Fed was simply to allow the markets to work through concerns. We believe the Fed paused on raising rates because they wanted to let markets digest the economic news from China, coupled with concerns over how the global economic slowdown would impact the U.S.

In late September, Janet Yellen stated she felt the Fed would raise rates later this year. In the past few weeks, a number of other prominent Fed officials have spoken publicly about expecting a December interest rate increase. This is an attempt to provide the market with plenty of notice to hopefully eliminate some of the volatility typically associated with a rise in interest rates. It should be noted that you only see interest rate increases when an economy can handle it, as such action tends to dampen economic growth. An increase in interest rates is a signal of economic strength.

We believe it is impossible to consistently and accurately predict what will happen in the market in the near term. This is because short-term market movements include emotional biases, which cannot be rationally predicted. Over longer time horizons, fundamental and economic data can be properly incorporated, while emotional biases tend to dissipate. We feel it is far more important to understand economic strength of countries, and where we are in the business cycle rather than speculating on the day-to-day gyrations of stock returns. Most importantly though, we need to understand your potential cash flow needs from your investment portfolio. We construct investment allocations based on individual cash flow needs, and as such, it is vital we do not subject money you may need to spend in the next couple years to the short-term whims of the market. A properly constructed asset allocation, which is based on client specific cash flow needs, risk tolerance, and time horizon, is far more important in achieving your investment goals than intra-quarter movements in the markets.

[1],[2],[3],[4] Morningstar Office 2013; Large capitalization domestic stocks as measured by the S&P 500 Index and the smaller counterparts by the Russell 2000 Index. Foreign stocks as measured by the MSCI EAFE ND Index and the emerging market stocks measured by the MSCI EM ND Index. Fixed Income / Bonds as measured by the Barclays US Aggregate Bond Index, Barclays Municipal Index, and the Citi World Government Bond Index.

The opinions voiced in this letter are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. The economic forecasts set forth in this printing may not develop as predicted and there can be no guarantee that strategies promoted will be successful. Stock investing involves risks, including loss of principal. Bond values will decline as interest rates rise and bonds are subject to availability and change in price. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.