The theme for this newsletter is volatility. Not only are we seeing volatility in financial prices, but also in economic data and in some indicators we use to gauge the market's risk level.
Recently we wrote that financial markets were eerily calm. Things got a little stormy in the third quarter. Large capitalization stocks in the U.S. managed to eke out a small gain (S&P 500 was up 1.1%) due to money flowing into concept stocks like Twitter (up 22%), but the rest of the equity world struggled. U.S. small capitalization stocks dropped over -7%. U.S. mid-capitalization stocks didn't do much better down around -4%. Emerging market and gold stocks were strong in the second quarter but fell sharply in the third as did developed market international stocks which declined by about -6%.
Most of the world has seen deterioration in economic data lately. The geopolitical situation is hitting Europe hard, and it is bordering on another recession. Recent economic data in China have spooked investors with fears of a slowdown. The lone bright spot is the U.S. where corporate profits are high, monthly job gains are regularly topping 200,000, and household deleveraging seems to have stopped. While improving, the U.S. economy is far from robust. There are still 3.3 million fewer full-time employees than in November 2007, an incredibly dismal statistic so long into the recovery.
Early in the year there was plenty of cautiousness, but sentiment conditions changed pretty dramatically as the stock market reached new highs. Margin debt is near all-time highs. A recent Investors Intelligence poll of U.S. investment advisors showed just 13% stock market bears, the fewest since 1987. A big red flag is now waving as a few prominent Wall Street strategists who were cautious all turned positive.
The key factor during this bull market has been the accommodation of the world's central banks. The European Central Bank (ECB) is increasing liquidity by purchasing up to €700 billion of asset-backed securities from countries in the European Union to reverse the shrinkage of its balance sheet which is down 13.6% in the past year. On the other hand the Federal Reserve is moving in the opposite direction which may offset the ECB's activity.
Besides the sentiment data discussed above there are several other warning signs. Reckless lending was the main culprit leading up to the financial crisis and many of the worst practices like covenant-lite leveraged loans are now back. Fixed income investors are chasing yield regardless of risk. Stocks are not cheap and by some measures are quite expensive. The current takeover boom and reliance on share repurchases for growth are classic signs of the final stages of a bull market. Finally, we just saw the largest initial public offering ever, Alibaba. Large IPOs almost always occur near market tops.
Short-term stock market movements are largely random and unpredictable. Ironically longer term predictions are generally more accurate because they are based primarily on starting valuations, which suggests long-term returns will be modest compared to the last five years. So while the recent volatility may not herald a big decline, it at least suggests big returns are not likely. We have been waiting for a change in volatility to signal the time become a bit more active in the portfolios, and recently we have raised some cash. Corporate earnings will be critical in the near term. If earnings season is weak this quarter, we may become more cautious.
Let us know if you have any questions.
Jim Tillar, CFA, Steve Wenstrup
