"As for foreign exchange, it is almost as romantic as young love and quite as resistant to formulae." - H. L. Mencken

As it has done so often since the cycle low in March of 2009, the stock market rallied following a correction in the dog days of August and the Dow Jones Industrial Average as well as the Standard and Poor’s 500 Index established all-time record highs in September. The recovery, nonetheless, was rather labored and the Dow’s net gain for the quarter was 1.3% without dividend reinvestment.

 Despite continued widespread concerns about the inevitability of rising interest rates, yields in the fixed income sector were up only modestly and the ten-year Treasury note futures contract thereby suffered a 0.7% decline for the period. Credit spreads, however, widened out, so returns in lower rated issues were disappointing.

 The biggest loser, however, was the commodities sector as the CRB Index posted a whopping 9.6% decline in the third quarter. Oil prices have led the way south but industrial commodities were part of the carnage as well.

 The big winner for the period was the oft-maligned U.S. dollar, which appreciated 7.6% against a basket of currencies including the euro, yen, Swiss franc, and others. More on this development anon.

 Real GDP was reported to have expanded at a 4.6% annual rate in the second quarter following the poor weather induced decline in the year’s first quarter. Whether such a pace can be sustained for the remainder of the year appears doubtful but there is at least a chance of matching the long-term trend growth rate near 3%.

 To wit, initial claims for state unemployment insurance benefits declined below the 300,000 level – a development suggesting that jobs growth could approach or surpass the growth rate of the labor force. To this point the decline in the unemployment rate, which now stands at 5.9%, has been as much a function of declining labor force participation as it has been jobs growth. This is the reason why income growth has remained muted, and, unless this situation changes, future GDP growth could prove to be lackluster, much as it has throughout the recovery thus far.

 Industrial production declined slightly in August but the supply managers’ survey continues to hold well above the 50% level, thereby indicating that the manufacturing sector is still growing. Housing starts, however, have been essentially flat albeit rather volatile on a month-to-month basis. It is difficult for the economy in general to exhibit strong growth without the participation of that critical sector.

 As indicated earlier, interest rates have been buffeted by the hot air emanating from the mouths of Fed watchers but the net result to date is that the Treasury yield curve has lifted only modestly above the lows for the cycle. Still, one cannot ignore the fact that the rate of monetary creation, while still rising in absolute terms, has dropped dramatically in recent months. In monetary matters, what occurs on the margin is paramount.

 In the sporting news, the Chicago Cubs failed to make the World Series for the sixty-ninth consecutive year. Speaking of losers, the Vanderbilt Commodores football team returned to their usual form (this is known as regression to the mean) after three consecutive seasons of bowl appearances. Only a missed last second field goal by UMass kept Vandy from going 0 for September.

 In other news, we have learned that a major solar flare in 2012 came very close to disabling a large number of communications satellites as well as the power grid. There is supposedly a 12% chance that those most unpleasant events could occur over the next ten years, so give your mother a call today.

 The Sun is not the only source of unpleasantness. The reported cases of unruly passenger behavior by 170 airlines (who knew there were that many?) have grown from 339 in 2007 to 8217 last year. Fly the friendly skies, indeed.

 September 19 was the day that the Dow established a new record closing high at the 17,279.74 level. On the New York Stock Exchange that day there were actually more declining stocks than advancing ones. This development is known as negative divergence and historically has been a warning that the market is running out of steam.

 Among the other signs of potential trouble are near record levels of bullish sentiment, high levels of margin debt and a record IPO to the tune of $25 billion by China’s Alibaba. (The reader can no doubt guess who the forty thieves might be.)

 As mentioned heretofore, the dollar advanced sharply last quarter. The foreign exchange markets are affected by all sorts of machinations and phenomena, so we are not pounding the table about a possible explanation for the dollar’s rapid ascent of late. Nonetheless, it is not unreasonable to think that at least part of the buck’s rally can be attributed to a flight to safety. Europe is barely growing, Japan’s economy has turned down and the Chinese financial system and economy bear a strong resemblance to a house of cards.

 Also noted above, commodity prices peaked in the spring and took a tumble in the third quarter. Meanwhile, yield spreads have been widening. The Russell 2000 made a high on March 4. The NYSE Composite made a high on July 3. Hence, over the last several months the markets have exhibited a move away from riskier assets toward those deemed to be safer. It appears that it is only a matter of time before the Dow and S&P come under pressure.

 The good news is that we have seen this before on several occasions since the market low in 2009. In every instance there was a moderate correction followed by a move to new highs for the cycle. The bad news is that all of that activity occurred while the Fed was injecting enormous amounts of liquidity into the financial system. Today, instead, the Fed is draining said liquidity on the margin.

Our initial thought was to include a chart of commodity prices with this letter but we have chosen not to do so because it is unpleasant and we have had a tendency to harp about commodity prices over the years. Hence, with our favorite season upon us, we are instead attaching a photograph recently taken in the high country of northern New Mexico.

 Enjoy the autumn weather and the confluence of baseball, football, hockey and basketball in October. And please note that we have carefully avoided any reference to the word, “Fall.”

   -  Weaver C. Barksdale, CFA

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