In a Nutshell
Like students invading our college town after a summer away, volatility abruptly returned in August. After commenting last quarter that the market had not strayed more than 3.5% from where it began this year, U.S. stocks dropped 12.5% from their May peak to their August lows and drove the VIX, an index that measures market volatility, to levels not seen since 2011. International stocks fared worse, with emerging markets taking the brunt of the damage.
High quality corporate and Treasury bonds, normally a safe haven during market drops, provided some help during the quarter, up a few percent. High Yield bonds, more closely tied to the stock market, fell in sympathy with stocks.
Commodities also suffered losses during the quarter. Gold, normally considered a safe alternative when other markets are in turmoil, continued its multi-year slide. One bright spot was commercial real estate, which bucked the negative trend and finished positive for the quarter.
It is often said that markets climb a wall of worry and currently there seems to be plenty to cause concern. Although the Federal Reserve has not begun raising interest rates yet, it’s only a matter of time before they begin doing so. Then there is continuing concern about the slowing Chinese economy and that it could drag the rest of the global economy down with it. And some investors are worried that the drop in company profits this year may not be temporary.
On the positive side, energy prices are down and consumers are keeping the U.S. economy stable by taking those savings at the pump and spending more in other areas. Auto sales and home building, two key economic drivers, continue to be strong. And the stock market will enter its 6 month seasonally strong period in November.
As always, we continue to pay attention to the markets and how our client portfolios are positioned.
Correction Territory for U.S. Stocks
With August’s market drop, stocks finally experienced a long overdue correction. Historically we get 10% pullbacks about once a year on average (Source: Standard & Poors). Prior to August, the last 10+% drop the market experienced was back in the summer of 2011, 4 years ago. These pullbacks are healthy for the markets as they serve to let a little air out of the balloon and remind investors that reward does not come without its risks.
With the poor quarterly performance, U.S. stocks ended September down for the year. Mid and small caps fared worse than large caps over the quarter but are still outperforming when looking at longer term trends. And growth outperformed value, continuing a trend that’s been in place for over a year and one that is reflected in our portfolios.
Looking below the surface, it’s no surprise to see that defensive stocks such as Utilities and other blue chip dividend paying stocks held up relatively well this quarter. What was more interesting is that technology stocks, normally very volatile, also fared much better than the broad market. On the other end of the spectrum, Biotech and Energy companies were the worst quarterly performers. Energy has had a tough year in general, largely due to declining oil prices. Biotech, on the other hand, has been a leading sector over the past couple of years. Time will tell if its poor performance this quarter is a blip or the beginning of a slower growth period.
Playing the Waiting Game
As would be expected when stocks drop, money flowed into the relative safety of high quality bonds, especially U.S. Treasuries. Bonds had spent the first half of the year in a downward trend, anticipating the Fed beginning a series of rate increases this year. The trouble with the Chinese economy evidently put a hold on those plans as the Fed ended the quarter leaving rates at essentially 0%.
When compared with other major asset classes, bonds are still in a favorable position, ranked 2nd behind U.S. stocks (Source: Dorsey Wright & Associates).
China! China! China! (In my best Jan Brady voice)
As much consternation as a slowing Chinese economy has caused in U.S. markets, the rest of the world, especially countries that are heavily dependent on exports to China, experienced more severe market drops. Adding insult to injury, low commodity prices also continued to impact countries dependent on raw material exports, such as Australia and Brazil.
The silver lining to the poor performance is that the risk/reward profiles in both developed and emerging market countries are compelling. One strategist estimates that developed international stocks represented by the EAFE index are at values not seen since 1970 (Source: Riverfront Investments). Of course, just because an investment is undervalued doesn’t mean it can’t stay that way for an extended period of time. This is an area we will be monitoring closely, however.
What’s Bad for Commodities is Good for the Consumer
As mentioned earlier, all the major commodities including oil and gold were down for the quarter, continuing a long-term trend. While lower raw material prices hurt energy and mining companies, they act as a tailwind for the U.S. and other consumption based economies.
Another positive for us as consumers is the strength of the U.S. dollar. While it has impacted profitability of U.S. companies that sell overseas, it keeps prices of imported goods lower. And with the Fed expected to begin raising interest rates in the near future, the dollar may continue its strength for a while. Time to plan that trip to Fiji!