US Stock Market 3Q Review: A Cautious Mood

The US stock market had rocky periods during the third quarter of 2014. There were concerns about rising geopolitical risk that impacted market sentiment. Those concerns triggered some abrupt, albeit minor, corrections. Volatility of the major averages within the quarter was restrained to single-digit declines. These masked some of the market shifts. On September 9, Bloomberg reported as follows:

Beneath the U.S. stock market's record-setting gains, trouble is stirring. About 47 percent of stocks in the Nasdaq Composite (CCMP) Index are down at least 20 percent from their peak in the last 12 months while more than 40 percent have fallen that much in the Russell 2000 Index and the Bloomberg IPO Index. That contrasts with the Standard & Poor's 500 Index (SPX), which has closed at new highs 33 times in 2014 and where less than 6 percent of companies are in bear markets, data compiled by Bloomberg show.

The key elements of geopolitical risk are the evolution of ISIL and its activities in Syria, Iraq, and the broader region known as the Levant. In addition, there is continuing turmoil in Nigeria, a primary oil source. A spreading Ebola epidemic adds to risk. There are also of course problems involving Russia and Ukraine and the responses of the US and European Union to that crisis. In addition, there are tensions in the South China Sea that do not always appear on the news media’s radar screen in the US. Developments there are gradually worsening.

The US stock market went through successive geopolitical risk shocks that started intensifying in July 2014 and have continued through the quarter. They are likely to be with us for many more years. The sources of these tensions are not going to be resolved easily or disappear. Geopolitical risk and all of its ramifications are here to stay.

Cumberland US exchange-traded fund (ETF) accounts raise cash when shorter risk profiles seem to intensify. That has been done twice during the third quarter of 2014. The exercise of ETF strategies allows cash to be quickly raised if risk levels intensify. The threat of the destruction of Mosul Dam in Iraq was one of those possibilities. ETF strategies also allow redeployment quickly. Thus one can be nimble with a portion of the funds in a portfolio if events trigger a change in risk premia. That has happened this quarter, and it may happen again. It is hard to predict such things.

As things proceeded to Labor Day weekend and after, our US ETF accounts were redeployed again in a fully invested structure. Then additional risk characteristics evolved. We measure various risk indicators constantly. The high-yield/treasury spread is one of them. It is widening. Small-cap stocks are underperforming large-cap. We have sold our small-cap positions. Energy prices are falling; we are underweight. And we are again maintaining a cash reserve. One of the best-performing sectors of the year is Utilities. Our US ETF models include an overweight in Utilities, and that decision has helped the performance of those accounts.

We look forward to ongoing very low interest rates for the rest of this year and into the beginning of 2015. After that, the path of interest rates is murky. The federal deficit has stopped shrinking and seems to be leveling off at about $500 billion. And the net interest cost of the federal budget has stopped shrinking after years of decline, due to very low interest rates. There is a high-risk inflection point in the present transition from Fed stimulus to neutrality, and market changes evidence it. We are cautious as we enter the year-end quarter, which is usually a favorable time for American stock markets.

BY David R. Kotok