Nola Kulig
Kulig Financial Advisors
Longmeadow, MA, 01116 USA
413-565-2839
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2014 Q3 Market Review: Volatility Returns

November 24th, 2014

This quarterly market review is a bit delayed. Nonetheless, we will take our regular temperature of the markets, with a bit of an update through October, since things keep changing. As usual, our goal is to look at recent market results, put them in perspective, and see how that experience should set our expectations going forward.

This post looks at the following topics:

  • 2014 Q3 Markets Review
    • Volatility Returns
    • Greenback’s Effects on Stocks
    • Why Europe, China and Japan Matter
    • Can the US Support World Growth?
    • Portfolio Implications

2014 Q3 Markets Review

Volatility Returns

Market reviews are great for keeping us honest as we witness the twists and turns in economic news and market results. You may recall from our earlier posts that there were three major themes dominating headlines early in the year: emerging market jitters early in the quarter, Russia’s incursion into Ukraine, and a long and brutal winter that negatively impacted economic results at home. Then the market shrugged all this off and just kept chugging along until hitting a rough patch in October.

When you look at the returns which follow, it is worth recalling that many market forecasters believed that the market “had” to fall in 2014 following a great year for stocks in 2013. However, the real surprise to many has been the strength of the bond market.

Overall observations for the quarter and year-to-date include:

  • For the broad market, September was a poor month which ended a flat quarter and a fine YTD.
  • For small stocks, September was a lousy month, which ended a dreadful quarter and YTD.
  • REITs have had a bumpy ride recently, but have had a solid YTD.
  • Emerging markets reversed their gains.
  • Long term bonds were surprisingly strong.
  • Gold has continued to lag, as have commodities more generally, especially oil.
Market Returns
Market Index September Q3 2014 YTD
9-30-2014
Stocks        
Large Cap S&P 500 Index    -1.4%  1.1%  8.3%
Midcap S&P Midcap    -4.6 -4.0  3.2
Small Cap S&P Small Cap    -5.4 -6.7 -3.7
Non-US Developed Markets MSCI EAFE    -3.8 -5.9 -1.4
Emerging Markets MSCI Emerging Mkts.    -7.4 -3.5  2.4
US Bonds Barclays US Aggregate    -0.7  0.2  4.1
REITs S&P US REIT    -6.0 -3.2 13.9
MLPs Alerian MLP    -1.6  2.7 19.5
Gold Dow Jones-UBS Gold Sub index Total Return    -6.0 -8.4  0.6
Commodities Dow Jones-UBS Commodity Index TR    -6.6 -11.9 -7.8

Sources: AJO Partners, Factset, Dow Jones Indexes

Although not shown in the above table, a major influence on markets in recent months has been the US dollar’s surge in relation to other currencies. The Dollar Index, which is a weighted average of the currencies of the nation’s major trading partners, has risen to its highest level in over four years.

There are two major reasons we are seeing a resurgence of the greenback, and it may bode well for stocks and the economy.

First of all, the U.S. economy is expanding at a faster rate than many developed nations. And growth attracts foreign cash as investing opportunities, including those in stocks, multiply.

In addition, for investors looking to park cash in safe, interest-bearing investments, a favorable rate advantage is also a magnet for capital. Short-term rates are near zero, but the U.S. has an advantage in bond yields, and the difference between longer-term Treasury bond yields and yields in a number of developed nations widened. Finally, the Fed recently concluded its quantitative easing program, and some expect that an eventual hike in interest rates could occur next year, although later than originally anticipated.

It’s a different story in Europe and Japan, where economic woes may encourage their respective central banks to increase monetary stimulus, keeping rates at rock-bottom levels for quite some time.

Greenback’s Effect on Stocks

Conventional wisdom suggests a stronger dollar will make exports less competitive and reduce revenues from sales overseas that are translated back into dollars.

This is a headwind for individual companies, but research by RBC Capital and the Schwab Center for Financial Research (SCFR) suggests the market as a whole won’t be hindered by a strong dollar.

RBC pointed out that a stronger greenback has historically been supportive of higher price/earnings ratios. And SCFR notes that the S&P 500 Index has performed nearly twice as well during dollar bull markets vs. dollar downturns. It’s not that stocks have fallen during dollar weakness; they just haven’t performed as well.

For now, the dollar is enjoying its day in the sun. There will be winners and losers across the economy, but there is a possibility that as a whole, the U.S. economy and the market could be the big winner.

Why Europe, China and Japan Matter

Europe continues to struggle economically, and it became apparent in October just how much. Even Germany’s economic growth rate slowed, and price levels continue to teeter on the edge of deflation. Unlike the U.S., Europe is struggling with a rate of inflation that is too low. That doesn’t sound like a problem to most consumers, but Europe isn’t far from slipping into what is called “deflation,” or a general decline in the price level.

Deflation continues to threaten as an economic black hole. It causes consumers and businesses to delay purchases, as they expect prices to decline further. It also makes the cost of carrying debt onerous. The two forces can contribute to a vicious cycle of declining economic growth, as some of the peripheral European countries have already experienced.  A look at Japan’s experience over the last 20 years also offers up a sobering example.

At the same time as Europe struggles, China’s growth rate is also slowing due to debt excesses in its own economy. Investor concerns over global growth caused markets to lurch downward in October. Commodity prices also plunged on perceived weaker global demand.

Since then, central banks have made reassuring noises about easy monetary policy, which caused markets to rise again. In particular, on Halloween, the Bank of Japan stated it would begin a new quantitative easing program. This Halloween treat sent global stock markets up sharply.

Can the US Support World Growth?

Many good things have been happening in the U.S. economy. There is increased employment, rising corporate earnings, rising end demand, a rebounding housing market, and an increase in consumer confidence. These factors, plus indications that the Fed is less inclined to tighten, have propelled our stock market higher.

The question at this point is whether the economic strength here at home will be sufficient to support the global economy. There is a chance it could work out, especially with supportive central banks around the globe. As regular readers of my newsletters know, I do not believe there is any real way to tell in advance how things will play out. One thing we can say, though, is that at this point, both U.S. stocks and bonds have had a good run. So we are overdue for a correction, which could easily happen.

Does this mean you should bail out of your investments? No, because the markets love quantitative easing. But more fundamentally, we simply do not know where world economics and markets will head. Earnings growth could catch up with stock price levels. Non-U.S. stocks look more reasonably valued than those at home, although they have economic growth questions (but then we never find bargain prices without some fundamental issues—if it were clear, the market would bid up those prices). If we continue to have issues with potential deflation globally, bonds could continue to at a minimum, remain stable. Or not. We simply cannot tell. Therefore, we should stay diversified.

Portfolio Implications

  1. Make sure you are taking no more risk than you can really bear for your financial situation

In discussions with clients, I have started describing the right risk level as the maximum you can bear under the worst market conditions and no more. We should add that it should also be the maximum you can bear under your own worst personal financial conditions. Please think in terms of your financial capacity for risk, not just your emotions as markets fluctuate, as important as that is.

So if you have job security, insurance covering the big financial risks, solid savings, little or no debt, etc. then your financial capacity is higher. In that situation, no matter how bad markets are, you have a good chance of riding it out and coming out financially whole.

If on the other hand, you are skeptical of job security/prospects, have not been saving adequately, have not taken steps to obtain adequate insurance, have way too much debt, etc. then perhaps you do not have a high capacity for financial market risk and should be more conservative.

  1. Don’t change your risk tolerance along with the rise in the market (or from fear it might fall)

Since 2008, I have rarely had anyone try to talk me into raising the risk level of their portfolio. But it is beginning to happen in more recent months. All I can say is please be extremely careful, and that the real driver of the risk level of your portfolio should be your financial circumstances, not just that the market has been going up. In fact, that temptation to chase performance can be dangerous to your financial health.

I also hear complaints about investments besides stocks. It is difficult to bear periods of extremely low rates, and many come to me saying they have cash “that just sits earning nothing.” Others hate bonds due to their extremely low rates, feeling that they will be damaged by rising rates.

Just remember that the stock market is also not cheap and cannot rise forever. Be sure to keep enough cash to cover emergency and other upcoming expenses, no matter that it will not earn much; if you are retired, keep a few years’ worth in case the markets are poor. Withdrawals in bear markets will deplete your capital.

And I would not dump bonds, as they will never be as volatile as stocks. Not to mention that using only cash and no bonds will put you behind after taxes and inflation.

  1. Rebalance

One advantage of market volatility is that it can provide an opportunity to rebalance portfolios. So if you haven’t reviewed your positions in a while, you may want to do that. Given the relative dominance of U.S. large cap stocks, you may need to purchase some small caps or non-U.S. stocks.

On that note, enjoy the upcoming holiday season, and try not to fret the markets too much!

Investment advisor representative of an investment advisory services offered through Garrett Investment Advisors, LLC, a fee-only SEC registered investment advisor. Tel: (910) FEE-ONLY. Kulig Financial Advisors may offer investment advisory services in the state of Massachusetts and other jurisdictions where exempted.