September 2013 Market Commentary

The third quarter is almost over and so far the market has not experienced the sell-off many had been predicting. The S&P 500 Index was down 2.9% in August, but the rally in stocks has resumed in September with the index up over 3.0% this month (as of September 10th).

Historically September and October have been the most volatile months of the year in the stock market, and this year stocks appear to be especially vulnerable. Stock valuations have been rising because the run-up in stocks has not been accompanied by improvements in corporate earnings. In the second quarter, earnings growth was negative outside of the financial sector. The recent rise in bond yields has the potential to slow the economy even more as its effect on housing and lending activity will begin to be felt in the fourth quarter.

With growth already set to slow, the many unresolved issues which will play out in the coming months add to the growing list of concerns for investors. Possible military action in Syria, the U.S. Federal Reserve's reduction of stimulus likely to begin sometime later this year, the potential for another government-induced crisis relating to the debt ceiling, and the sharp uptrend in Treasury bond yields all have the potential to disrupt investors' appetite for owning risky assets such as stocks.

While most investors are currently piling into U.S. stocks, we believe that the Emerging Markets present an intriguing opportunity. Ever since the Fed first began to telegraph it will soon begin the process of unwinding its stimulus, stocks in the emerging markets have dropped substantially. As a result, emerging market stocks appear extremely undervalued relative to the growth potential in these economies and have the potential to outperform their developed-market counterparts over the next several years.

Investors are concerned that as rates rise in the United States, the higher rates that can be earned in the U.S. will cause capital to flow out of the emerging economies and into the United States. At this point the price of stocks in the emerging markets appears to fully reflect the potential outflow of capital from these countries. While growth in some emerging markets is slowing it is still faster than the developed world's, and if the Fed does slow its bond buying and interest rates rise the stronger dollar will make imports from the emerging economies more competitive, which will spur additional growth in these countries. On the other hand, if growth in the U.S. falls short of the Federal Reserve's projections, which is likely, the Fed might delay tapering until 2014.

Some emerging countries are well positioned for growth regardless of what the U.S. Fed does. In particular, countries with current account surpluses and have companies with lower levels of debt are more likely to withstand significant capital outflows. China is one such country. Chinese stocks are cheap, and the economic data coming from China continues to show improvement.

Brian S. Sommers, CFA Director and Portfolio Manager

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