2015 Autumn Newsletter – Third Quarter Review 10/30/2015

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We look forward to the fall. Indeed, September could be one of the best months of the year to be in Maine: the weather is terrific, the crowds thin out and there aren’t as many bugs. But for the financial markets, the beginning of autumn is often just the opposite—particularly the month of September. As you can imagine, there’s no shortage of market pundits hypothesizing why, on average (not every year, but an average of many years going back to 1950), all the major stock market indices have dropped as much 1% in the month of September alone.

This September lived up to its reputation and then some with the S&P 500 Index shedding more than 2.6% of its value. But the decline had started well before then. From its peak on May 21st, the S&P 500 plunged 10%–enough of a drop to be classified as a “correction.” With this correction, the U.S. stock market landed not only in negative territory for 2015 to the tune of nearly 7%, but was also down over 3% from this time last year. As we noted in our August 24th communication with you, a market correction is a fairly normal, if not annual occurrence. In fact, until this year, we’d experienced one of the longest stretches in history without one.

Needless to say, we’re happy to see the third quarter—our first full quarter as an independent registered investment advisor—come to a close. The performance numbers presented to you in the enclosed Quarterly Performance Report, reflect just that—the third quarter ending September 30th 2015 and, as it so happens, one of the market’s worst quarters in a number of years.
Fortunately, stocks have rallied back with a vengeance, and so has our performance. Since hitting bottom on August 24th, the S&P 500 has already recouped more than 10% of its value–mostly in sectors that had become oversold—energy, industrial and international names for instance. For that reason, we have enclosed a performance overview for the month of October as well. But now that we’ve had this nice bounce, we’d like to also give you a sense for what we think about the coming quarters:

Market volatility is likely to continue, at least until some near term issues are clarified and fear and negativity subside. For instance:

• Federal Reserve policy: Since early this year, the Fed has been telegraphing its intention to begin raising the fed funds rate. Nothing happened at the September meeting, so now all eyes are on the December meeting. Whatever the decision is, the markets will react. Looking ahead, we do not see any evidence to suggest that the pace of the Fed’s tightening cycle will be a fast and steep one.

• China: The world’s second largest economy is slowing as it transitions from an infrastructure-driven to consumer-led economy. Many of the figures related to manufacturing activity are trending down, which is taking its toll on companies with exposure there. At the same time, however, indications from the consumer and services sector are positive. We believe the Chinese government will continue to implement policies that prevent anything more than a deceleration in economic activity there.

• Emerging Markets: China is the world’s largest consumer of commodities. But commodities and the emerging market countries that produce them had been in a tailspin even before worries about China surfaced and are now trading as though we are in a global recession. While we don’t anticipate that occurring in the coming year, we doubt 2016 will see robust growth from that region.

We see opportunities in equities:

• The U.S. economy has been resilient, thanks to the American consumer, and we still expect steady improvement through the remainder of this year and next. New home sales are up double digits, unemployment claims recently fell to the lowest level in 42 years, auto sales are at 10-year highs and construction spending is growing at the fastest pace in almost a decade. Wage growth has been disappointing, but lower oil prices should help boost incomes. Even so, the pace of Gross Domestic Product growth is likely to slow from the second quarter’s upwardly revised 3.9% rate.
• Central Banks in Europe and Japan are pursuing monetary policies that should spur economic and therefore stock market recoveries in those regions.
• Valuations – as measured by the widely followed price to earnings ratio — have come down to more reasonable levels. This is especially true in the Eurozone and Japan, where valuations are more attractive compared to the U.S.

Our investment philosophy stays the same:
• Stocks may continue to rally through the end of this year thanks to a decent earnings season in the U.S. and indications of economic stimulus in Europe and Japan. However, we caution that we have likely entered a period of more modest returns on U.S. stocks. The market has come a long way since hitting bottom in 2009, averaging a compound annual return of over 15% for the past five years, so it’s safe to say the stock market and economic recovery are in a fairly mature stage.

• We use a disciplined approach to security selection, in which we pay close attention to the price we are paying for a company’s earnings growth prospects. Even before this summer’s correction, certain segments of the U.S. market had traded down to levels not seen in years, particularly those that fall into what’s considered the “value” as opposed to “growth” styles. As the chart below illustrates, the gap in performance between the Russell 3000 Value index and the Russell 3000 Growth index is the widest it’s been in a decade. There are blue chip names – many that fall into the value camp – that have been hit hard, in spite of their time tested resilience: Warren Buffet’s Berkshire Hathaway, Oracle, Wal-Mart and Procter & Gamble, are among the biggest detractors from the S&P 500’s performance this year. In fact, if it weren’t for just a handful of high priced stocks in the Internet space—referred to as FANG, for Facebook, Amazon, Netflix and Google–the U.S. market would be negative for this year as opposed to up 2%. We will be managing the equity portion of your portfolios in order to own quality companies trading at reasonable valuations.

Growth vs value chart

Fixed Income

  • We continue to be cautious in our approach to fixed income. The Fed is determined to raise interest rates, which means there is risk to owning fixed income securities with long durations. It remains to be seen however how much rates can move on the upside as higher rates tend to place downward pressure on economic growth. For now, we prefer to remain invested in shorter and intermediate term bonds.

We remain concerned about managing risk, not only within our equity exposure, but in making sure your portfolio has broad diversification and the appropriate mix of asset classes, including fixed income, to suit your risk tolerance and investment objectives. We look forward to meeting with you in person soon to discuss your investment performance, our outlook, and how we are helping you reach your goals.

 

Cribstone Capital Management LLC. (“CCM”) is an SEC registered investment adviser located in the State of Maine. The firm and its representatives are in compliance with the current registration and notice filing requirements imposed upon SEC registered investment advisers. CCM may only transact business in those states in which it is notice filed, or qualifies for an exemption or exclusion from notice filing requirements. For information pertaining to the registration status of the firm, please contact the SEC on its website atwww.adviserinfo.sec.gov. A copy of the firm’s current written disclosure brochure discussing the firm’s business operations, services and fees is available from CCM upon request.

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