For the third quarter, the S&P 500 Index was up +1.13% including dividends. The variance between the best and worst sectors was vast. Sector performance was split down the middle with five of the ten sectors posting gains while five posted losses. Health care gained +5.03% in the quarter due to large gains in the most risky slice of that industry, biotechnology. Energy was decimated losing -9.15% due to concerns over the strengthening dollar and lower demand. Year to date, the S&P 500 is up +8.34% while the Dow Jones Industrial Average is up +4.61%.
Volatility ticked up after a prolonged period of slumber. Geopolitical events such as threats of war in the Middle East and Russia, terrorism, and disease have influenced the volatility, and concerns about economic growth both here and abroad continue to echo. Barring external geopolitical shocks, we believe the domestic economy will continue to grow at a subdued rate.
The equity market has now passed the three year mark without a 10% correction. Decades of market history suggest corrections are a more typical occurrence in the investment experience, even in long-term bull markets. While we would not predict that the stock market is ‘overdue’ for a correction, we do want to remind investors that they are more common than recent experience suggests. Rather than a reason to panic, a correction would be an opportunity for discipline and commitment to your asset allocation strategy.
Regarding equity portfolio performance, while there are bright spots, we acknowledge that we have not kept pace with our benchmark this year. In particular, our investments in companies in the energy and agriculture-related sectors have performed poorly, while we have had little exposure to strong areas like biotechnology, high multiple technology stocks, and utilities. We continually test both our thesis and valuation measures of our investments in energy and agriculture, and we would not hesitate to shift those investments should either measure turn negative. At this juncture, we maintain our conviction that in a world that is becoming more global, with a rising middle class in huge emerging markets, our energy and agriculture investments have attractive potential for growth and trade at very reasonable valuations, especially compared to other sectors of the market. Sectors that we have avoided, such as biotechnology and some segments of technology, have fascinating implications for our health and culture and have performed well this year. But many of these companies carry significant risks, such as a single drug or product, and trade at valuations that require
tremendous earnings growth and perpetual operating excellence to justify their price from our fundamental perspective. Given our fundamental approach, we are likely to lag our benchmark any time it is led by stocks with stretched valuations. But we are confident that over a full market cycle we will see valuations revert on both the low and high end, and we will participate while moderating the risk taken in the portfolio.
Speaking of our benchmark, we have used the S&P 500 Index including dividends since our inception to compare equity returns. While we share some common criticisms of the S&P 500 (it is market cap weighted and has a momentum bias), it is also well known and widely reported. The S&P 500 represents essentially the 500 largest public U.S.-based companies. Our portfolios, on the other hand, will be overweight or underweight certain economic sectors versus the S&P 500 based on our fundamental research. Additionally, because we are a core equity manager, our portfolios will include large allocations to mid-cap and small-cap stocks, as well as international developed and emerging markets. Our portfolios are very intentionally constructed to look different than the index and performance differences, both positive and negative, should be viewed from that perspective. Our goal has always been and will continue to be to generate attractive long-term risk-adjusted returns.
In the bond market, rates fell slightly for the quarter as volatility continued. Our market barometer, the 10 Year Treasury, began the quarter yielding 2.53% and ended the quarter at 2.49%. That doesn’t sound like much until you realize the high in rates for the quarter was 2.64% and the low was 2.33%, having almost reached 2.64% in both July and September. For the quarter, the Barclays Intermediate Government/Credit Index was essentially flat at negative -0.03%, bringing YTD returns to +2.21%.
For the year, rates have fallen considerably from 3.03% to 2.49%, again with major volatility along the way. At the latest Federal Reserve meeting the governors cut quantitative easing by the scheduled $10 billion per month. The remaining $15 billion is scheduled to be eliminated in October. The consensus seems to be, and we agree, that the first rate hikes are likely to occur in mid-2015.