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2018 Third Quarter Market Report

If you believe that the trend is your friend, then perhaps the U.S. stock market is in for an excellent fourth quarter. U.S. equity markets suffered small losses in the first quarter, followed by decent single-digit gains in the second quarter. Now that the third quarter is in the books, a somewhat larger gain has put stocks in solid positive territory for the year.

The Wilshire 5000 Total Market Index—the broadest measure of U.S. stocks—finished the quarter up 7.27% and has gained 10.68% so far this year. The comparable Russell 3000 index is up 10.57% in calendar 2018.

International stocks are not faring quite so well. The broad-based MSCI EAFE index of companies in developed foreign economies gained just 0.76% in the recent quarter, and is now down 3.76% for the year. Emerging market stocks of less developed countries, as represented by the MSCI EAFE EM index, went into negative territory for the quarter, down 2.02%, for a loss of 9.54% for the year.

Our global equity fund, DFA Selectively Hedged Global Equity (DSHGX) finished up 2.33% for the quarter and is up 2.70% for the year.

Looking over the other investment categories, real estate, as measured by the Wilshire U.S. REIT index, gained 0.72% during the year’s third quarter, and is just eking out a 2.25% gain for the year. Our global REIT fund (not an apples to apples comparison to the US index), DFA Global Real Estate (DFGEX) finished the quarter up 4.94%, and is up 2.83% for the year.

The S&P GSCI index, which measures commodities returns, gained 1.34% in the second quarter, up 11.84% for the year. Our commodity fund, DFA Commodity Strategy (DCMSX), again not an apples to apples comparison as DFA isn’t as concentrated on oil as the index, underperformed the index and finished the quarter down 7.26% and is down 3.52% for the year.

In the equity-like portion of our model portfolios we saw Ironclad Managed Risk (IRONX), a strategy that sells put options on equity indices and exchange traded funds, was up 1.11% for the quarter and up 7.56% on the year. AQR Style Premia Alternative Fund (QSPIX), a strategy that invests long and short across six different asset groups: stocks of major developed markets, country indices, bond futures, interest rate futures, currencies and commodities based on four investment styles: value, momentum, carry, and defensive, lost a disappointing 4.06% for the quarter, making them down 8.28% for the year. Rounding out the mix of equity-like funds, Steben Managed Futures Strategy (SKLIX), had a quarterly gain of 2.62%, putting them down 3.83% for the year. We have these funds in our portfolio to produce returns that are not influenced by the equity markets, so in that regard they are performing as expected.

In the bond markets, coupon rates on 10-year Treasury bonds have continued an incremental rise to 3.06%, while 30-year government bond yields have risen slightly to 3.21%. But short-term yields are catching up; 3-month Treasury bills are now paying investors 2.20%, and one-year Treasuries yield 2.56% on an unusually flat yield curve. Normally, bond investors have to be paid much more to hold longer-term paper, due to the always-present uncertainties in interest rate movements and other factors.

Our high quality bond funds, DFA Selectively Hedged Fixed Income (DFSHX), closed the quarter up 0.63%, up 1.05% for the year, and DFA Global Core Plus Fixed Income (DGCFX) was up 0.90% and is flat for the year. Our Treasury Inflation Protected (TIPs) fund, DFA Inflation Protected Securities (DIPSX) was up 0.18% for the quarter, down 0.19% on the year, while our high yield bond fund, Principal High Yield (PHYTX), finished up 1.88%, and is up 0.96% on the year.

What’s going on? The American economy roared in the second quarter of the year, but most economists believe that the 4.2% GDP growth number was inflated, both by short-term corporate earnings as a result of the tax cuts, and by a short-term effort by multinational companies to complete as much overseas business as possible—including via their manufacturing supply chains—before the widely-publicized tariffs took effect.

That suspicion seems to have been confirmed by a variety of new economic statistics. On the jobs front, initial claims for state unemployment benefits rose by 12,000 to a seasonally-adjusted level of 214,000—above expectations. On the manufacturing front, non-defense capital goods orders excluding aircraft, a proxy for business investment, fell 0.5% in the recent quarter. As a result, Morgan Stanley and Barclay’s economists lowered their growth estimates to 2.7% and 2.8% for the third quarter. This is solid but not spectacular growth, a bit above the 2.2% growth rate the U.S. economy has experienced, on average, since mid-2009. Altogether, we may be looking at a year of 3% growth.

But then you have the Federal Reserve Board’s recent (and widely anticipated) decision to nudge the Fed Funds rate up to a range of 2-2.25% in September and to raise short-term rates again in December. Higher short-term rates are not necessarily bad for the market, and it is certainly a good sign that Fed economists believe the U.S. market is strong enough not to need additional stimulus. But the Fed seems to be intent on continued raises next year, when the biggest impact of the corporate tax rate reduction will be behind us, and when we enter unknown global trade territory due to the imposition of tariffs on U.S. trade partners.

I still have to wonder how long the party can continue. Nobody knows what tomorrow will bring, but everybody knows that bull markets don’t last forever. As I have said time and time again, get mentally ready for the downturn.

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