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Third Quarter Recap

Stock Market
The U.S. stock market, as measured by the S&P 500 Index, posted its first quarterly loss since the second quarter of 2010 and its largest quarterly decline since the depths of the Great Recession in the fourth quarter of 2008 with a loss of 13.9% in the third quarter of 2011. The Index had increasingly larger declines in each month of the third quarter, with the 7.0% decline in September marking the fifth consecutive monthly decline for the Index and the largest one-month decline since the 8.0% decline in May 2010; the Index declined 2.0% in July and 5.4% in August. Some of the same issues that impacted the market during the second quarter of 2010, notably the European debt problems, had a similar impact in the third quarter of 2011.

For the year thus far, the S&P 500 Index has posted a -8.7% return. The third quarter was a battle between the strongest quarter of economic growth this year and the increasingly negative investor and consumer  sentiment. Economic data, while not pointing to robust economic growth, suggested the economy continues to expand, albeit at a painfully slow pace that is well below historical averages at this point in an economic recovery. In that sense, the slow pace of growth probably feels like a recession to many investors. Those feelings were reflected in consumer and investor sentiment surveys that were decidedly pessimistic in the third quarter. However, the gap between what investors say they are doing (i.e., consumer sentiment) and what they are actually doing (i.e.,  consumer spending) is wide. On balance, negative sentiment overwhelmed the market in the third quarter and remains an overhang for investors as the fourth quarter begins.

In dissecting sector performance of the U.S. equity markets, defensive sectors generally outperformed cyclical sectors in the third quarter. Utilities was the only sector to post a gain in the third quarter with a return of 1.6%. Utilities is the best performing sector in the S&P 500 Index yearto-date with a return of 10.7%. With the stock market lower and interest rates below 2.0%, investors have looked to the Utilities sector given its defensive nature and healthy dividend yield of approximately 4.4% (as of September 30, 2011). The notable outperformer among cyclicals in the third quarter on a relative basis was the Technology sector, which posted a decline of -7.7%. The performance was notably worse among the other cyclical sectors – Energy, Materials, Industrials, Financials – which all declined more than 20% in the quarter on concerns of a global economic slowdown.

Materials was the worst performing sector in the third quarter with a drop of more than 24%. From a market capitalization perspective, large-cap stocks outperformed their mid-cap and small-cap counterparts as large caps tend to be more defensive in nature. From a style perspective, there was not much of a distinction in returns between growth and value. The Russell 1000 Growth Index, a proxy for Large Growth stocks, was the best performing domestic asset class in the third quarter with a return of -13.1%, as Technology stocks significantly outperformed. The Russell 2000 Growth Index, a proxy for Small Growth stocks, had the biggest decline among the nine style boxes with a drop of 22.3% in the quarter.

For the second consecutive quarter, U.S. stocks outperformed their Large Foreign and Emerging Market counterparts on a relative basis, though the magnitude of outperformance was far greater in the third quarter. The MSCIEAFE Index, a proxy for developed foreign markets, declined 19.0% in the quarter due in large part to the woes in Europe. France and Germany each witnessed declines of more than 25% in their domestic stock markets during the quarter and now reside in “bear market” territory with declines of more than 20% in 2011. Similar to the second quarter, the MSCI Emerging Markets Free Index had the worst returns of the major world indexes in the third quarter, declining 22.5%. Brazil’s stock market declined 17.5% in the quarter and is down 24.5% year-to-date, while China declined 14.5% in the quarter.

Economy
Much like the second quarter, economic reports in the third quarter were again uneven, introducing fears of a global economic slowdown, which contributed to market volatility and overwhelmingly negative sentiment.

While many of the reports came in below expectations, they did not suggest a return to recession.

With regard to economic growth, gross domestic product (GDP) continued to hit new all-time highs in the second quarter. Second quarter GDP was revised higher late in the third quarter from 1.0% to 1.3% annual growth. The third quarter is on pace to grow at a 2 – 2.5% rate, the strongest growth rate so far this year. The second quarter revision was due in part to better-than-expected consumer spending, which remains robust with 4.6% year-over-year growth in same-store sales as of the end of August. The Index of Leading Economic Indicators (LEI), which is a grouping of several economic statistics that are usually predictive of future economic conditions, continued to suggest slow growth and not a doubledip recession. In fact, LEI posted a solid and better-than-expected gain in September – the fourth straight month of re-acceleration in the year-over-year growth of the LEI – which suggests that a recession is unlikely. Despite the lack of recessionary indicators, however, consumer sentiment was near 30-year lows in the third quarter, as measured by the University of Michgan Consumer Sentiment report.

Over time, these consumer spending and consumer sentiment measures are highly correlated as the more confident consumers feel, the more likely they are to spend money. However, the recent periods have seen a near historic disconnect, as consumers are filling out surveys suggesting a dismal outlook, but not significantly adjusting spending. Consumers are acting differently than they are feeling. The fundamental data shows that consumers, which make up nearly 70% of the U.S. economy, are going to the malls and spending at levels not seen since 2007. However, that fundamental data flies in the face of the sentiment data, which suggest consumers are as gloomy and pessimistic as they were at the depths of the 2008 recession.

Troy, Tyler and Ansel