Presented by Joe Smalley, Accredited Investment Fiduciary® 

Markets slip as risks return

August was a difficult month for financial markets across the board. The Dow Jones Industrial Average fell 4.11 percent—performing worst of the major U.S. indices—while the S&P 500 Index declined 2.90 percent. The Nasdaq did best, losing 1.01 percent.

Losses were driven by a mixture of external risks and internal market factors. External risks included turmoil in Egypt, which potentially threatened the Suez Canal; a higher probability of U.S. intervention in the Syrian civil war; and interest rate volatility caused by the possible Federal Reserve (Fed) “taper” of bond market support. Completion of the corporate earnings season, with a slowing growth rate for both the revenues and earnings of U.S. businesses, also depressed market sentiment.

Besides the fundamental picture, the change in investors’ appetite for risk was apparent in the technicals. The S&P 500 dropped through its 50-day moving average mid-month and, after a brief rally, continued to decline. This was not definitive—the S&P 500 also spent time below the 50-day average in late June and early July before recovering—but it was a sign of weakness (see chart). If prices continue to decline, the technical weakness could become more pronounced. Interest rate-sensitive sectors, such as consumer staples, telecommunications, and utilities, were the worst laggards, while the previously embattled materials and technology sectors held up reasonably well.

The S&P 500 Index broke below its 50-day moving average and is near its 100-day moving average.

International markets were mixed but generally stronger than U.S. markets. Developed international markets, represented by the MSCI EAFE Index, lost 1.32 percent, while the MSCI Emerging Markets Index also did better than U.S. markets but still gave up 1.90 percent.

Fixed income markets outperformed equity markets, although they could not escape the effects of rising interest rates. The benchmark 10-year Treasury bond yield rose over the month, from 2.58 percent to 2.78 percent, driving losses in the fixed income indices. The Barclays Capital Aggregate Bond Index was down 0.51 percent for the month. Performance was worst for international and, particularly, emerging market bonds, which suffered a 2.89-percent loss, according to the JPMorgan EMBI Global Core Index, as investors repatriated assets into U.S. dollars. Bank loans and short-duration bonds performed relatively well because of their lower correlation to changes in interest rates, but investors still saw a small decline in these asset classes.

Earnings growth above expectations but still modest

At the end of earnings season, according to FactSet, earnings growth came in at 2.1 percent, which was above the 0.6 percent that analysts had predicted. More than half of companies beat revenue estimates, while almost three-quarters beat consensus earnings-per-share estimates. This was good news. Even so, both results were below average compared with the past four years, and overall earnings growth results for the quarter were the third lowest in four years, also according to FactSet.

Much of the earnings results were dependent on the strong performance of the financial sector; excluding financials, aggregate earnings actually declined 3 percent. This broad weakness may continue, given that 85 of the S&P 500 companies have issued negative guidance for the third quarter—only 19 companies have issued positive guidance.

The declining growth rate and discouraging trends in forward guidance combined to make investors more cautious, as demonstrated by the broad-based declines in stock prices. Although equity prices were still at historically high levels, the declines from their peaks suggested that investors were moderating their expectations. Volatility, also an indicator of investor risk appetite, increased in August, with the CBOE Volatility Index (a.k.a., the VIX Index or the “fear index”) rising from 13.5 to 17, an increase of more than 25 percent.

Political risks trump economic risks in August

Although the slowing growth rate for corporate earnings was certainly a factor in the market declines, political risks dominated the headlines. Investors began to debate in earnest whether the Fed would start to taper or reduce the volume of its bond purchases in September. According to a Bloomberg poll taken in mid-August, 65 percent of the economists surveyed expected at least a small reduction in monthly purchases, with the median respondent predicting that purchases would fall from $85 billion to $75 billion per month. If tapering does occur, this would likely continue to put pressure on certain asset classes, particularly emerging market bonds and equities. If the Fed decides not to taper, these assets could experience a significant rally.

Though the likelihood of tapering on the part of the Fed appeared to increase in August, speculation regarding that possibility was overshadowed by uncertainty over who would succeed Ben Bernanke as Fed chairman. The campaign between supporters of Larry Summers and Janet Yellen brought into relief the potential for unexpected changes in Fed policy.

Another concern is the pending debate in Congress over securing funding for the new fiscal year and raising the debt ceiling. In late August, the U.S. Department of the Treasury announced that it would run out of maneuvering room on the debt before the end of October. Investors remember the 2011 debt ceiling debate, which led to a significant market correction, so they will likely watch events in Washington closely.

Finally, the very real potential for U.S. involvement in Syria also acted to unsettle markets. The use of chemical weapons in Syria sparked heightened rhetoric about the possibility of U.S. and allied military intervention. The price of internationally traded Brent Crude oil spiked from $108 per barrel at the beginning of August to $114 at month-end. U.S. stock markets were also affected. The Dow fell 170 points as Vice President Biden announced he had no doubt that Syria had used chemical weapons, and speculation increased that an intervention would occur.

The real economy continues its recovery

Despite the political risks, the real economy continued its slow recovery. Housing slowed, driven by an increase in rates. According to the Wall Street Journal, 30-year mortgage rates have risen from 3.7 percent at the beginning of the year to 4.6 percent at the end of July. Though the rise in rates was largely sparked by Fed Chairman Ben Bernanke’s comments back in May, the data has only recently suggested that his words have had an appreciable effect on housing demand. Notably, the volume of new home sales fell more than 13 percent in July. At this point, however, the slowdown in housing appears to be a healthy adjustment, as values continue to increase and sales remain strong.

Even with the headwinds in the housing market, however, unemployment claims remain low and consumer confidence is still strong. Leading indicators ticked up during August, and growth for the second quarter was revised upward to 2.5 percent—a result of much stronger-than-expected exports, apparently driven by economic improvements elsewhere in the world.

This is a healthy reality check

The increase in interest rates and declines in stock prices reflect the renewed realization by investors that there are significant political and economic risks going forward. This realization is actually constructive, as it has introduced an element of caution and helped keep valuations real. The ongoing recovery in the real economy, although moderating as housing slows, also seems well supported.

The rise in rates and decrease in earnings growth also represents, in many ways, a normalization of the markets and the economy. As the Fed starts to exit, and as companies increasingly compete based on a normally growing economy, we can expect some volatility; however, once the transition has been made, the economy should be better placed to grow in the future. For now, it makes sense for investors to maintain their long-term perspective, knowing that, despite potential short-term volatility, the overall long-term trend is favorable.

 

Disclosure: Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets. All indices are unmanaged and investors cannot invest directly into an index. The Dow Jones Industrial Average is a price-weighted average of 30 actively traded blue-chip stocks. The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. The Nasdaq Composite Index measures the performance of all issues listed in the Nasdaq Stock Market, except for rights, warrants, units, and convertible debentures. The MSCI EAFE Index is a float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI Emerging Markets Index is a market capitalization-weighted index composed of companies representative of the market structure of 26 emerging market countries in Europe, Latin America, and the Pacific Basin. It excludes closed markets and those shares in otherwise free markets that are not purchasable by foreigners. The Barclays Capital Aggregate Bond Index is an unmanaged market value-weighted index representing securities that are SEC-registered, taxable, and dollar-denominated. It covers the U.S. investment-grade fixed-rate bond market, with index components for a combination of the Barclays Capital government and corporate securities, mortgage-backed pass-through securities, and asset-backed securities. The JPMorgan EMBI Global Core Index is a subset of the broader JPMorgan EMBI Global Index and measures the performance of most liquid USD-denominated emerging market sovereign or quasi-sovereign bonds. The EMBI Global Core Index includes fixed, floating-rate, and capitalizing bonds with a minimum outstanding of $1 billion USD and a minimum remaining maturity of 2.5 years. Eligible countries are those classed by the World Bank as having low or medium per capita income for 2 consecutive years, or countries that have restructured their external debt over the last decade. The CBOE Volatility Index (VIX) is a market estimate of expected volatility that is calculated by using real-time S&P 500 Index (SPX) option bid/ask quotes. VIX uses near-term and next-term out-of-the money SPX options with at least 8 days left to expiration and then weights them to yield a constant, 30-day measure of the expected volatility of the S&P 500 Index.

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Joe Smalley is a financial advisor located at 213 E. Saint Joseph Street, Lansing, MI 48933.  He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. He can be reached at (517) 487-4850 or at www.smalleyinvestments.com.

Authored by Brad McMillan, vice president, chief investment officer, and Sean Fullerton, investment research analyst, at Commonwealth Financial Network.

© 2013 Commonwealth Financial Network®