Volatility is Back
Ups and Downs
The third quarter of 2014 was nothing like the second quarter. The second quarter saw increases in just about every investment category that we use. This past quarter was one of new volatility in the markets. Bonds and stocks both spent the period going from highs to lows, then reversing course and reversing course again.
The month of September was a down month for equities, as the weight of world conflict and the worry of increasing interest rates encumbered the market. On the other hand, high quality bonds did well during September. With turmoil and conflict in many parts of the world, the U.S. became the safe haven for risk-shy investors. As money poured into high-quality bonds from many foreign countries, interest rates dropped while values rose. As foreign investments flowed into the U.S., the dollar grew in strength against most currencies, including the Euro and the Yen. This in turn resulted in declines in most foreign investments, due to currency devaluation against the dollar.
Looking at the numbers for the quarter, we see the S&P 500 nearly static. The quarter opened with the index at 1960.23 and closed on September 30th at 1972.29 or up 0.6%. During this period, the S&P went from a low of 1909.57 in August to a high of 2010.40 in September and then back down to the closing of 1972.29. The range from the low to the high was over 5%. This is a rather significant rate of fluctuation. Even going from the high on September 19th to the closing at the end of September the change was about 2%. This downward trend continued at the beginning of October. It may be that we are finally facing the long-expected correction to the overall stock market. A correction would be a downward change of about 10%. We have already seen this happening with small stocks. The Russell 2000, which is an index of small stocks, went from a high of 1208.15 on July 3rd down to 1101.68 at the close of September, a decline of 9.7%. We may well see this trend play out with medium-sized and larger stocks as well.
First quarter economic growth was very weak, following a strong fourth quarter in 2013. The given reason for this weakness was the terrible weather across the U.S. during that period, coupled with the high cost of gas. The second quarter turned in very significant growth, with the economy growing at a rate of 4.6%.
As we entered the third quarter of this year, the expectations were for a strong rate of growth. The third quarter turned out to be a rather bumpy road, with the economy slowing down in July, rallying in August, then turning down again in September. The Conference Board’s index of consumer confidence fell in September to 86 from 93.4 in August. The same lackluster sentiment appeared with the Chicago Business Barometer, falling from August to September from 64.3 to 60.5. Investor confidence in the economy seems spotty. With Europe having almost no growth, China having far less growth than they need to sustain their economy, and the rest of the world lagging behind the U.S., the U.S. still appears to be the engine of growth.
The Role of the FED
One of the major concerns this year has been the impact on bond values as the Federal Reserve (FED) ceases the purchase of bonds and mortgages. Since January, the FED has been gradually reducing these purchases from $85 billion monthly, with the program scheduled to cease at the end of October. Thus far the impact on the bond market and mortgage markets seems to have been minimal.
The result of the reduction in FED purchases has not interrupted a rather stable bond market. The high quality side of the bond market has actually shown prices rising as interest rates have dropped. The reduction in interest rates, as previously noted, is a worldwide flight to safety, with the U.S. seeming to be the safest place to invest your money. In turn, this has increased the value of the dollar, which for many years has been rather weak. The Wall Street Journal Dollar Index is up 8.6% since last October and finished the third quarter at a four-year high.
As the European Central Bank and the Bank of Japan attempt to deal with slow growth and low inflation, they will tend to loosen monetary policy. This will bring interest rates to new low points in their respective countries, making investing in the U.S. a better alternative with higher relative interest rates and greater chances of economic growth. This should benefit the U.S. stock market going forward as international investors will see currency-transaction gains as well as appreciation of assets beyond what is available in their own countries.
Looking to the Future
Stock market prices can be volatile. We have witnessed this in the past and are witnessing it now. This can belie the long-term prospects of the stock market. As I’ve said in the past, we have four fundamental things going for us in the U.S. We have political stability, a growing wealth of energy resources, high worker productivity and high-quality workmanship. These are likely to produce a period that is unparalleled in recent U.S. history. I believe we are looking at a powerful expansion of the U.S. economy, such as in the early 1980s and 1990s.
All is not necessarily rosy, however. As I said in my July newsletter “I expect that sometime in the next six months, we will see a stock market correction” and I believe we may now be in such a correction. This would bring the price of stocks down by about 10%, making them even more desirable as investments. For now we will have to soldier on, acknowledging that markets do go down as well as up. I don’t believe you can time the market. Once again, diversification is important, for both asset classes and assets within each class. Diversification should help to mitigate major fluctuations in investment portfolios.
The market experiences times when the long-term outlook is very good, but the short-term doesn’t appear to be very good. This seems to be one of those periods. We are long-term investors and should be taking the long-term approach. The ride may be bumpy, but I believe it will all be worthwhile, as we see the U.S. economy continue to expand. More manufacturing, greater technological breakthroughs, and increasing employment should all lead to greater earnings for consumers and an escalating economy. The future of the U.S. is very bright but all is not perfect.
posted Thursday, October 9, 2014 at 3:23PM