Quarterly Update

The third quarter (Q3) of 2018 brought new highs for U.S. stocks, volatility overseas, and the continued trudging along of the bond market. Politics held most of the headlines during the quarter, both at home and abroad, but stocks were largely able to ignore this as various aspects of the U.S. economy remained strong.

Here's a summary of how major market indexes ended the quarter and year-to-date:

• S&P 500: up 7.7%; up 10.6%
• Down Jones: up 9.8%; up 8.3%
• Russell 2000 (small company stocks): up 3.6%; up 11.5%
• MSCI EAFE (foreign stocks): up 2.1%; down 1%
• MSCI EM (emerging markets): up 0.5; down 7.4%
• U.S. Aggregate Bonds: about flat; down 1.6%
• Municipal Bonds: down 0.1%; down 0.7%

Top performing sectors in Q3 included Technology, up about 8.4%, and Healthcare, up over 14%. Poor performers included Utilities and Energy, up about 1.5% and 0.4%, respectively. Real Estate was flat.

Across the U.S. economy companies are generating more revenue, consumer confidence is up, investors are generally more "bullish", and other key indicators are positive. The Institute for Supply Management's Manufacturing Index just dipped below 60 (readings above 50 are said to be "expansionary") but is still elevated, even amid tariff concerns.

While this growth has been good for stocks, it has weighed on bonds. For some time, the bond market has been trying to "price-in" assumptions about how quickly the Fed will continue to raise interest rates as the economy grows. With three increases this year and one more expected, bond investors have readjusted prices downward (prices move in the opposite direction of interest rates). The Fed's projections seem to indicate more increases during the next year or so, followed by a leveling off. This path is uncertain, however, so the bond market could continue to be shaky in the near-term.

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Domestic stocks outperformed foreign stocks during the quarter, extending a trend from earlier this year. Emerging market stocks fared worse due largely to currency issues and trade concerns. Developed markets in Europe, for example, also lagged on concerns including looming Brexit deadlines and political problems in Italy. In both cases, politicians struggled to build consensus around the tough decisions required to move their governments and economies forward.

Right at the end of the quarter we saw a long-awaited shakeup in market sectors. Two index providers, Standard & Poor's and MSCI, maintain the Global Industry Classification Standard (GICS). GICS assigns publicly traded stocks to specific sectors based on the kind of business the firms are in. This enables investors to assess (and invest in) specific sections of the economy (utilities, industrial firms, etc). This classification system doesn't change very often because making changes has broad ramifications.

Among those ramifications are that we now have the Communications Services sector where we once had Telecommunications. Telecom was small at about 2% of the S&P 500 (the primary U.S. stock index), but the new broader sector will make up almost 10% of the index.

Going forward, companies like Walt Disney, Comcast, Netflix, and Alphabet (Google) that had been in the Consumer Discretionary or Technology sectors will join stalwarts like AT&T and Verizon in the new sector. This makes the Consumer Discretionary and Technology sectors smaller, from about 13% and 26% of the S&P 500 down to about 10% and 21%, respectively.

This reshuffling happens behind the scenes at the index providers and in the funds that track the indexes, but the coming weeks could see some volatility as investors shift their portfolios in response.

So, U.S. markets were mostly quiet amid all the political noise during Q3 and the economy seems to be chugging along. However, economic growth is cyclical and will eventually begin to slow. This hasn't happened yet but we're getting closer each quarter. In the meantime, it's probably prudent to start getting mentally (and financially) prepared for when the next stage of the economic cycle presents itself and volatility rears up again.

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