Events like the IRS scandal, Egyptian political problems, Obamacare missteps, NSA phone taps, China’s credit crunch, the Benghazi disaster, and Japan’s economic instability were not significant enough to disrupt the stability of the U.S. stock market in the quarter just ended.

On the other hand, most foreign stock markets were noticeably weak during the period, and the abrupt increase in interest rates caused a temporary 6% correction of stock prices and an even greater correction for stocks that pay above average dividends. This hurt prices for stocks like utilities, which declined 2.73% for the quarter. On the other end of the spectrum, financial stocks led the way with a 7.25% gain followed by consumer discretionary stocks at +6.81%.

Overall, the S&P 500 increased 2.91% for the quarter. Growth stocks outperformed in the small and mid-cap space, but it was value stocks that took first place in the Large Cap arena. The average U.S. domestic mutual fund increased 2.29%, the average Foreign Stock fund was off 2.2% and taxable bond funds declined 2.43%.

Our experience in the most recent quarter continues to bolster the opinion held by many fund managers that the market continues to be decoupled from the overall economy as a result of unprecedented intervention by Central Banks worldwide. This is evidenced by the spike in volatility we observed at the mere hint that the US Federal Reserve may begin tapering its current stimulus effort known as QE3. Moving forward, we expect Federal Reserve policy to remain accommodating as the fundamentals of the economy have leveled off and in some areas have even begun to deteriorate.

While these policies have been bullish for stocks to this point, the longer they continue without substantial improvement in the economy, the greater the risk of periods of higher volatility for which our newly revised hedge is well suited. Add to this the uncertainty over the continued implementation of Obamacare, the first major city bankruptcy in Detroit, the ongoing tax and budget battles in Washington DC, and you have an environment where unhedged portfolios could experience uncomfortable P/L swings.

Still, over the near term, we do not believe we are on the verge of a new recession and that equities, with proper protections in place will continue to be the place to be invested.

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The investment climate was remarkably good during the first quarter.

With the exception of the financial melt-down of the tiny island, Cyprus, and some late in the period saber rattling by the North Koreans, investors benefited from a virtually crisis free environment. The housing industry continued to improve. Corporate profits were modestly higher and above expectations. Economic growth was mostly steady and only softened with the uncertainties created by the sequester. And finally, stock market volatility dropped sharply and more than half of the ten economic sector stock price indexes posted double digit gains for the quarter.

The Health Care sector led the way with a 15.22% gain while both Technology and Basic Materials came in below 5% for the period. The S&P 500 reported a total return of 10.61% for the period and the average diversified domestic stock mutual fund was up 10.2%. Small Cap stocks outperformed large company stocks and value (defensive) stocks outperformed growth issues in most areas. In the fixed income area, the Intermediate Government/Credit Bond Index increased just 0.26%.

Given the above average strength of the stock market over the past six months, it is not unusual for the market to pause or pull back for a period of time.

In addition, the April to May period is a typical seasonal period during which such corrections have occurred in the past. It is not necessarily usual, however, for the markets to undergo a major decline unless stocks are extremely overvalued, economic conditions deteriorate substantially or something catastrophic like another financial meltdown occurs. Stocks are not excessively expensive based on historical standards, and in our opinion, economic conditions are holding and another financial meltdown is not in the cards.

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A Five Part Chill Ride

From an attitude of complete complacency throughout 2013 and through the summer of this year, investors are suddenly beginning to take fright. But, what, exactly, are they afraid of? Here’s a short list of things that seem to be going bump in the night.

1. October

   This is probably the least frightening thing, but it is true that historically, October is the most volatile month of the year. Whether this has to do with mutual fund jockeying before the end of the fiscal year or pre-holiday jitters, no one knows for sure. What the market has shown so far this month is not out of the norm.

2. Fed tightening

   The Federal Reserve continues to rumble about eventual tightening. At the same time, it repeatedly assures that any interest rate increases will be slow and measured to make sure the economy doesn’t crumble in response. Can we trust them? Do they know how to deliver what they promise? If the past is any guide, rate increases will probably provide something of a bumpy ride for the market.

3. Geopolitical problems

   From ISIS, to Russia, to China, to our own southern border,there seems no end to geopolitical worries now that our government has stepped back from its traditional center stage role in international affairs.

   • ISIS has taken large chunks of territory in both Iraq and Syria. It sits on the border of Turkey, a member of NATO and is threatening Jordan and Lebanon. ISIS has announced their intention to bring down the government of Iran and to hijack that country’s own contentious nuclear program. Furthermore, they have ambitions to infiltrate terrorists into the US through our virtually unguarded border with Mexico. Certainly, if they can destabilize Turkey, take down Iran, or manage a large scale terrorist attack within the US, the fallout could be damaging to the market. Russia and China have both taken much more aggressive military postures of late.
   • Russia, of course, has annexed Crimea and is making at least a small scale war in eastern Ukraine. Obviously, part of the motivation is pure opportunism, but at what point will the West call Putin’s bluff. If it is a bluff. Russia’s economy runs on oil and with the oil price having come off signifcantly of late, it will be intereting to see if that take the wind out of Putin’s sails, or, on the other hand, further motivate him to be adventurous abroad to divert his public’s focus from a stalling economy.
   • China, too, is flexing its military muscles. With tens of millions of young men with no chance of finding a bride, thanks to its misguided “one child policy”, the testosterone levels in China’s armed forces must be unbelievable. So far, China has been limited to bullying Japan and trying to push the US Navy around a bit in the waters off the Chinese coast. Nonetheless, China’s tone and actions have been worrying enough to push Japan to the point where that country is rethinking its commitment to post WWII pacifism.
   • So much has been written about our southern border problems that it’s hard to add anything new. Nonetheless, it should be repeated that a lack of control of who enters the US could lead to severe internal security problems in a worst case scenario.

    

4. Ebola

   With the first reported US fatality, a fatality and confirmed case in Spain, and worries about suspected cases in the UK and Australia, the fear of Ebola and its possible consequences is certainly onthe rise. Beyond the health fears, though, lies a fear that points a potential dagger at the heart of the market. The economies of the countries hardest hit by the plague, Liberia and Sierra Leone, have virtually collapsed. Could a similar chain of events bring the US economy, or the world economy, to a standstill?

   Western medicine is certainly light years ahead of the healing arts in west Africa. The medical authorities in developed countries claim that they are prepared and that there will be no pandemic in Western nations. But the apparent bungling of cases in Spain and here in Dallas leave the public, and the market, skeptical.

5. Global economics

   While the US seems to be making slow but fairly steady progress, things are not so good in other corners of the globe. The European economy is definitely slowing, as are Japan and China. Can a weak, but recovering, US economy withstand the headwinds from the rest of the world? At 10/9/14’s close of 1928.21, the S&P 500 is only 4.5% off its most recent intra-day high of 2018.66, set back on September 19th.

The market was certainly ripe for a correction, at least, and whether this dip turns into more than that may well be known by the time Halloween arrives.

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