In the third quarter, the economy continued to rebound from the disappointing weather-impacted first half of 2014. After a 2.1% decline in GDP in the first quarter, second quarter results indicate an increase of 4.6%. With this increase, there are signs that growth in the economy is beginning to accelerate. Car and truck sales have strengthened to a 16.3 million unit rate, nearly matching the prerecession record. Durable good orders in August were 9.0% above a year ago led by huge increases in aircraft orders. Other encouraging news was the continued improvement in consumer confidence (+13.0%) and an increase in leading economic indicators (+7.7%). 

The news on the inflation front is very encouraging – up only 1.7% over last year as measured by the Consumer Price Index. The Producer Price Index, prices that businesses pay for goods and services, was up a modest 1.9% over the prior year. Both of these are good news for interest rates as inflation and interest rates are closely correlated. The 10-year treasury rate fell from 2.97% at year-end 2013 to 2.49% on September 30. This was a surprise for us, probably because of the very slow economic start in the first quarter. We continue to expect rates to increase as the economic recovery gains strength, but we think that may not be until 2015. This gives Federal Reserve Chairman Janet Yellen more latitude to maintain low short-term interest rates. This should be good for financial asset prices in the short-term.

Employment trends are more or less stable. The total number employed is 147 million people, up 1.6% over last year and enough to lower the unemployment rate to 5.9%, just below the Federal Reserve’s long stated target rate of 6.0%. Of concern is the decline of the labor force participation rate, which is reflected in the reduced number of citizens seeking employment. This in turn can be seen in a slowing labor force growth. More worrisome is the fact that many of the jobs being created are low-paying part-time positions, and the full-time positions being created are paying less than the jobs lost in the recession.

Source: FactSet

As positive as the news is on the domestic economy, much of the rest of the developed world is not enjoying our positive trends. The on-again, off-again recovery in continental Europe seems to be stalling, possibly because of growing questions as to whether Russian gas supplies needed to fuel the European economies will be available. Another concern is that at the end of the quarter, Ford Motor Company announced that it was lowering its 2015 pre-tax profit forecast by $1.5 billion due to difficulties in Europe. Also, uncertainties linger as to the status of China’s inscrutable economy as well as concerns about other southeast Asian economies, where economic information is often unreliable. Finally, demonstrations in Hong Kong over democratic election issues underscore the fragile underpinnings of many of the world’s governments.

US stocks scored further gains in the 3rd quarter with the S&P 500 increasing 1.12%, bringing the YTD return to be 8.35%. During the quarter, both the Dow and S&P 500 established new all-time highs on several different days, but record corporate profits are also being achieved which supports these valuations. In addition, low inflation rates are positively impacting valuations as low inflation rates have generally been accompanied by higher price-to-earnings multipliers. Yet, it has been three years since we have had a meaningful correction of 10% or more, and we are entering October, which has historically been one of the most treacherous months for common stocks. Also, reason for concern is that the Dow Jones Industrial Average price has reached our 2014 target range of 17,000 to 17,500. Looking beyond 2014, we expect a resumption of world economic growth and believe that historical long-term 10% returns associated with common stocks can be achieved over the next 3 to 5 years. Conclusion: short-term – maybe rough tides, long-term – smooth sailing.