The third quarter was capped by a weak September which resulted in the worst quarterly stock performance in the last four years. After six years of positive annual returns a market correction was inevitable. While highly anticipated, the timing and the magnitude of a correction was unknown. The third quarter answered the timing question, although the jury is still out regarding the magnitude.

On the surface the market seemed irrational during this period of heightened volatility, but there were clear linkages between the cause and effect of economic events, policy decisions and market reactions. Let’s review what happened and suggest likely outcomes in the upcoming quarters.

Multiple factors aligned to create pricing pressure on stocks, high yield bonds and commodities in the third quarter. Downward pressure on commodity prices led by oil’s second leg down raised concerns about emerging market economies and the energy sector itself. The economic slowdown in China caused wild stock market swings within their market and this spilled over to stock markets around the globe. Central banks here and abroad rushed to relieve any short-term pain. In Europe, a U.S. style quantitative earning program is underway. In China, they devalued their currency which is pegged to the dollar. In emerging markets, there has been an expansion of local debt. In the United States, the Federal Reserve Bank decided to maintain their zero interest rate policy. The market interpreted this as a no confidence statement from the Fed and stock prices immediately fell. Add some geopolitical risk and the correction recipe is complete.

For the quarter, U.S. stocks continued to be the best horse in a weak field. The S&P 500 lost 6.44 percent, while the international markets were down 10.23 and 17.90 percent respectively, as measured by the MSCI EAFE and MSCI Emerging Markets indices. High yield bonds, which are highly correlated to the stock market, fell 4.86 percent during the period. This dragged both the year-to-date and trailing twelve month numbers into negative territory. Commodity price weakness continues to exasperate the markets, declining 14.47 percent in the quarter. The only bright spot was the investment grade bond market. The yield on the 10-year U.S. Treasury rallied back to the two percent level causing bond prices to rise. The Barclays Long-Term U.S. Treasury index was the best place to be this quarter with a 5.08 percent total return.

The message here is to hold diversified portfolios. As we begin to look toward the fourth quarter and into next year, we see stocks recovering and bonds maintaining value in a low interest rate world. The 2015 stock market struggles are functions of lower oil prices, a strong dollar, weaker than expected earnings, and slow economic growth. The commodity and dollar headwinds will turn into tailwinds in 2016 as values stabilize and earnings improve.

Volatile markets always test investor resolve. It has been smooth sailing for the past few years, and the third quarter was a rude wake up call. Successful investors have clear goals and objectives and the ability to remain focused on their long-term goals. This difficult quarter is setting the stage for a better 2016. Chart your course, stay your course.

MARKET BY THE NUMBERS:

In a much anticipated announcement the Federal Reserve decided to keep the Fed Funds rate at the zero to 0.25 percent range. This is the seventh year the rate has been in this exact range, since it was cut in the throes of the recession in December, 2008.

Recall that the Fed has two mandates: controlling inflation and maximum, sustainable employment. So why did the Fed choose to maintain record low rates? The three main reasons were:

1. Very low inflation in the US Normally Fed rate hikes occur when inflation is on an upward trajectory. Inflation (ex-food and energy) for August was 1.8%, below its 2.0% target.

2. US jobs While the unemployment rate has come down to 5.1% from its 10% peak in ’09, those participating in the labor force are declining as a percentage of the total. This has been on the decline for seven years now.

3. A fragile global economy There were several mentions of China in the follow up commentary, and slowing global growth overall. Any US rate hike would likely divert investments from overseas markets. It would also further strengthen the US dollar, which in turn would further cut into sales of US products to overseas markets, impacting US multinational companies.

The decision was not unanimous, however. The dot plot shown below indicates each Fed member’s rate expectations. Of the 17 voting members, 13 selected a higher interest rate range by the end of this year. The plot also shows that Fed members project rates will be even higher in the coming years, to the 3.5% area at the end of 2018 and longer term.

Does this mean that the Federal Reserve is currently taking a hands-off policy on the US economy?

We don’t think so. What most people don’t realize is that the Fed is equipped with other tools besides changes to the Fed Funds rate when it seeks to heat up or slow down our economy. Some of these tools are:

• The “overnight” discount rate which the Fed effectively pays banks for keeping money set aside from lending. By reducing the discount rate, banks are given more of an incentive to lend their deposits to growing businesses.

• Buying and selling securities. As we’ve seen with three quantitative easing (QE) programs over the last several years, the Fed can buy up or sell off securities in an effort to change rates.

• Public statements. The Fed will give forward guidance about the path for short-term interest rates. These statements tend to move markets prior to any official rate hikes.

Oftentimes, as shown in the graph below, the Fed encourages early market moves in interest rates since their decisions are based on data that is generally accessible. In the yellow boxes we can see that market interest rates (the blue line) move before the Fed changes the actual Fed Funds rate (the red line).

We may see a drop in the “overnight” lending rate in the coming weeks in an effort to stimulate US economic expansion. Back in 2007, the Fed expanded this service to as much as 30 days. We will be watching closely for changes to the program, since there are usually no announcements.

We believe a rate hike to the 0.25 to 0.50 percent range over the next six months (perhaps as early as next month) is being telegraphed by ongoing Fed governor commentary. When they do raise rates, we believe it will be interpreted as positive for the stock markets as it will indicate that the US economy and corporate profits are on more solid ground within a larger, global scope. Additionally, we believe that further rate hikes will be gradual (lower and slower). This was part of Fed Chair Yellen’s presentation to Congress last spring, that a more gradual path was a prudent approach.

So long as we do not have runaway economic growth and roaring cost inflation, which we do not expect, we believe a normal 10-year Treasury bond range of 2 to 4 percent is likely for the next several years.

As of September 22, 2015:

Dow Jones US Moderately Conservative Index is down 1.97% (TR) for the year

S&P 500 closed at 1,942 down 4.21% for the year

Russell 2000 closed at 1,143 down 4.26% for the year

U.S. 10-year Treasury Futures are yielding 2.13% down 4 basis points for the year

WTI Crude Oil futures closed at $45.13 down $8.58 for the year

Gold closed at $1,132 per ounce down $51 for the year

If this had been an actual emergency, you would have been instructed to buy gold and turn off the television. Seven months of flat markets tested patience, and the August stock market correction tested resolve. A 10 percent equity market correction in a handful of trading days is a serious gut check and a reminder that volatility lives.

The volatility index (VIX) chart of activity year to date shown below clearly shows the volatility alarm sounding in mid-August.

Portfolios provide valuable feedback on the risk we own. An instant correction, like the August experience, allows us to put personal dollar signs on the market move. It acts as both a financial and an emotional checkpoint. Use this mid-term exam as a chance to ask yourself:

– Do I have a financial plan that considers income, expenses and reasonable growth expectations?

– Do I have too much risk in my portfolio? Too little risk?

– Do I have enough liquidity? Am I positioned to take advantage of market opportunities?

– Emotionally, how did I handle the correction? Was I thinking about buying the sell-off or sprinting to cash?

The U.S. stock market has generated six consecutive years of positive returns, and a record breaking seventh year is questionable at this stage. During August the stock market provided the elusive 10 percent correction from its May peak that everyone was waiting for, so now what? The correction’s origin was rooted in China as slower expected growth from the world’s number two economy sent commodity and stock prices lower. We expect the remainder of 2015 to be a power struggle between the bulls and the bears. The final answer for 2015 is likely to be a flat year. This third quarter correction becomes next year’s opportunity.

We see 2016 having better corporate earnings as a strong dollar and weak oil prices are already reflected in the numbers. We believe the 2016 year-over-year comparisons will be viewed favorably by the global equity markets.

The U.S. bond market provided temporary shelter to an unsettled stock market. Stock volatility sent bond prices higher and interest rates lower. In a typical flight to quality, the 10-year U.S. Treasury yield dipped to a 1.90 percent yield before settling into a month end yield of 2.21 percent, virtually unchanged from the end of July. Meanwhile the 30-year Treasury yield finished up 3 basis points to 2.95 percent.

The Fed Funds rate debate continues, and investors now speculate whether it will be September, December or early 2016 for the first rate hike. Some of the data point to a September hike, but December seems most likely to me given the market jitters. With six years at zero interest rates, what’s a few more months? More interesting will be what the Federal Reserve reveals in its first meeting following the eventual rate hike.

Stock markets had a tough but resilient month as prices recovered somewhat at month-end from larger losses in the third week. The S&P fell 6.03 percent while higher-risk NASDAQ stocks declined 6.70 percent. Utilities was the best performing sector, while Energy was the worst.

The broad Bloomberg Commodity Index provided a bit of relief for the diversified investor. After months of negative returns the index posted a slight 0.92% dip in August as energy prices, a key component, posted sharp gains in the final days of trading.

Volatile markets test investor resolve. It has been smooth sailing for the past few years, and August was a great reminder as to why we diversify portfolios and manage risk. Successful investors have clear goals and objectives, remain focused on their long-term goals and stay resolute during their financial journey. The remainder of 2015 will continue to test investor resolve. This is a healthy exercise and will yield long-term benefits.

MARKETS BY THE NUMBERS: