Stocks posted strong results in the third quarter of 2016 as investors were encouraged by a modest improvement in economic conditions and a continuing supportive stance by central banks. The S&P 500 Index generated total returns of 3.9% for the third quarter. Riskier equity sectors, such as small company and emerging market stocks performed even better, returning 9.1% and 8.3%, respectively. During the quarter the S&P 500, Dow Jones Industrial Average, and NASDAQ Composite each recorded new all-time highs.

The table below shows the performance of major equity indices for various time periods.

Equity Performance for Periods Ending on September 30, 2016

Total Return Index Market Sector Quarter YTD 1-year 3-year 5-year 10-year
S&P 500 Large U.S. Companies 3.9% 7.8% 15.4% 11.2% 16.4% 7.2%
Russell 2000 Small U.S. Companies 9.1% 11.5% 15.5% 6.7% 15.8% 7.1%
MSCI EAFE Developed Int’l Markets 5.8% -0.9% 3.5% -2.2% 4.4% -1.0%
MSCI EM Emerging Int’l Markets 8.3% 13.8% 14.1% -2.9% 0.5% 1.5%

Heading into the third quarter there was some concern that U.S. economic growth was stalling. Real GDP growth for the previous two quarters had been 0.9% and 0.8%, compared to an average growth rate of about 2.0% over the six years prior (from 2010 to 2015). GDP growth for the period ending June 30, 2016 came in at 1.4%, marginally better, but still below average since the start of the current economic expansion.

Since the beginning of the Great Recession in December 2007, central banks around the world have taken a very active role in stimulating economies by implementing policies which have kept interest rates at or near historically low levels. These actions were originally considered to be extraordinary in nature, but necessary due to the severity of the global economic crisis. The plan was to gradually return interest rates to normal levels as the economy gained strength.

While some might argue whether or not the Fed’s policy has stimulated economic growth as intended, there is no doubt that the Fed’s suppression of interest rates has produced higher stock prices. Low interest rates have allowed companies to significantly lower their borrowing costs, which has permitted them to issue debt to buy back shares, to make acquisitions, and to pay higher dividends—actions which support higher stock prices.

With lower interest rates fueling higher stock prices, it seems that anytime the Fed hints at the possibility of an interest rate increase, stock markets react negatively. For example, during the third quarter a number of leading economic indicators demonstrated positive trends. A consensus developed that the economy was improving, but not fast enough to warrant an interest rate hike in September. With this perceived clarity came stability—stocks experienced one of their longest stretches of low volatility—a 43-day period when the S&P 500 moved less than 1% each day. This relative calm was disrupted when a Federal Reserve Branch President suggested that rates may be increased at the Fed’s September meeting. The S&P 500 fell 2.5% on the day of his comments only to fully recover when the meeting passed without an increase.

Considering that stock performance has recently been significantly affected by monetary policy, there are several possible outcomes to the current situation. One possibility is that economic growth accelerates, the economy expands for several more years, inflation increases moderately, and the Federal Reserve gradually raises interest rates to historical norms without major market reactions. Another possibility is that growth slows despite the ongoing low interest rate environment and a recession eventually materializes. At this point, we are still optimistic that the first scenario will play out. U.S. employment is at record levels and consumers appear to be willing to spend, with strength demonstrated in retail, auto, and housing sectors.

Lower interest rates have also helped to make stocks more attractive relative to bonds. The dividend yield on the S&P 500 is currently at 2.0%. The yield on the 10-year Treasury bond is 1.61%. Not only does the average stock generate more income than a Treasury bond, it also has the potential for significant capital appreciation over the same holding period.

Going forward, low interest rates alone are probably not enough to move stock prices higher. Historically, stock prices have been highly correlated with corporate earnings. In this regard, the recent earnings trend has been weak. Analysts are currently forecasting a year-over-year earnings decline for S&P 500 companies in the third quarter. This would mark the eighth consecutive quarter in which earnings underperformed the year-ago period, a trend that is expected to reverse soon. For 2017, earnings for S&P 500 companies are estimated to increase approximately 13% compared to 2016.

While the stock market has been focused on current U.S. economic trends and central bank policy, a number of other factors are likely to influence stock prices in the near term. Foremost among these issues are the outcome of the U.S. presidential election, changing economic trends in major foreign economies, the direction of energy prices, and geopolitical dynamics. Despite these uncertainties, we consider equities to be reasonably valued for long-term oriented investors.

Bond indices delivered mixed results for the third quarter. While the Barclays Aggregate Bond Index produced returns of 0.5% for the third quarter, the Barclays Municipal Bond Index lost 0.3%. The yield on the 10-year Treasury bond rose slightly during the third quarter from 1.49% to 1.61%. We continue to view long-term fixed income investments as risky, as these securities will perform poorly if interest rates rise to historical levels. To manage this risk, we have invested primarily in short duration fixed income investments in balanced portfolios that we manage.

John D. Frankola, CFA

The author is the president of Vista Investment Management, LLC, a Registered Investment Advisory firm. Under no circumstances does this article represent a recommendation to buy or sell stocks. This article is intended to provide information and analysis regarding investments and is not a solicitation of any kind. References to historical market data are intended for informational purposes; past performance cannot be considered a guarantee of future performance. Neither the author nor Vista Investment Management, LLC has undertaken any responsibility to update any portion of this article in response to events which may transpire subsequent to its original publication date.