Navigoe Third Quarter 2014 Market Review: Stormy Seas

Just when we had become accustomed to the smooth sailing that the markets had been delivering, we are reminded that stormy seas are part of the journey of being invested in the stock market.After three years of steady gains, market prices took a healthy step backwards. Among all major equity asset classes, only large cap U.S. stocks eked out a positive return for the quarter. In what has become a common occurrence over the past three years, as investors become spooked they seek the relative safety of the U.S. dollar and big U.S. companies. In fact, investors avoided risk across the board as small cap stocks trailed large companies, just as value trailed growth, both in the US and overseas.The widely followed S&P 500 index of large U.S. companies gained 1.13% for the quarter, bringing its year to date results to a return of 8.34%. Small cap stocks, measured by the Russell 2000 began September in positive territory for the year, but lost 6.05% in the most recent month. For the quarter it lost 7.36%, and year to date is now 4.41% in the red. As mentioned, value stocks fared worse, as the large cape value index, Russell 1000 Value, dipped 0.19%, and the small cap value index, Russell 2000 Value, slid 8.58% for the quarter.Overseas, stocks lost ground across the board, and just as in the U.S., small and value sustained larger losses. The large cap growth EAFE index of non-U.S. developed country stocks lost 5.88% for the quarter, bringing its year to date results to -1.38%. The value oriented version, the EAFE Value lost 6.20% last quarter, and is just underwater at -0.57% for the year. The EAFE Small Cap and EAFE Small Cap Value indices lost 7.82% and 8.41% respectively, bringing both of them into negative ground for the year at -2.74% and -2.32% respectively.International stocks portfolios are invested and measured in dollar terms, meaning that significant currency fluctuations impact returns. This past quarter saw the U.S. Dollar strengthen considerably relative to other major currencies. The Euro, Pound and Yen lost 7.75%, 8.08%, and 7.27% compared to the dollar.Why is the dollar strengthening relative to other currencies? Certainly a case can be made that the Euro is in decline because the continent continues to decline economically. The Great British Pound spiraled due to uncertainty around Scotland’s possible secession. And Japan is enduring its third decade of deflation and an aging population.The other perspective is simply that the US dollar is gaining due to strong economic fundamentals. Low to moderate inflation, strong corporate balance sheets, and declining (slowly) unemployment are possible reasons for the dollar’s strength. Another reason may simply be that investors were spooked, and retreated to the dollar as the perceived safe haven currency.Regardless of the reason, just like the stock market, relative dollar strength has its ups and downs. The longer term effects of a stronger dollar are cheaper imports and more expensive exports, which is bad for US companies, thus bad for the US economy, eventually weakening the dollar. In that way, currencies act as a sort of self-correcting mechanism to maintain balance across the economies of nations that transact with one another.As usual, nobody has a sound explanation for the recent stormy stock market seas. Or, more specifically, those attempting to explain it all have different reasons. Nonetheless, we continue to ask because it would be comforting if there was a clear cause.Some have suggested that markets were simply overvalued and due for a decline. This may be accurate, but history has shown that valuation measures make for particularly poor market timing tools. As an example, the commonly cited CAPE (Cyclically Adjusted Price Earnings) ratio, developed by Yale’s Robert Shiller, has remained at relatively high valuations since the early 90s.Shiller, himself, states that the ratio has been a very imprecise timing indicator. He goes as far as asking why stock price valuations have remained relatively high, proposing several theories. He suggests that relatively high bond prices are also propping up stock prices. A theory that seems to suggest that stock and bond prices should be highly correlated, but history has shown that not to be the case. He also posits that post-financial crisis, working people are investing in more stocks out of fear of losing their job. To the contrary, my experience has been that people who are fearful of losing their job are less, not more, likely to take risk with their capital.In the end, Shiller attributes high stock valuations to social psychology – an irrational exuberance. While investors have mostly been pleased with returns since the 2008-09 market crash, sentiment is not near the exuberance of the dot-com frenzy of the late 1990s or the real estate boom leading up to 2007.Interestingly, we seek explanation for the recent market slump just as Shiller and other market pessimists seek explanation for high valuations. Ironically, it seems that we come to the same conclusion. Social psychology, and the madness (or wisdom) of crowds is as likely as any the cause for the short term stock market decline. Investors hear that the market might be overvalued, so nervous investors sell, triggering a possible domino effect of selling – a herd mentality.Recently, this herd mentality has led to greater market volatility as active, emotional (fearful and greedy) investors attempt to guess the next big move. October started with 7 of the first 9 trading days seeing the S&P 500 gain or lose more than 1%. Contrast this with only 21 such days out of this year’s previous 188 trading days. The short term fluctuations garner headlines and the attention of investors. What they don’t report is that the global economy is made up of the companies that provide the goods and services that we, consumers in that economy, use on a daily basis. That economy is still growing.We don’t know what the psychology of investors will be tomorrow and what that will mean for markets. However, we do know that value, through investing, is built over time, regardless of investor sentiment today.Please let us know if we can answer any questions.All the Best!Scott A. Leonard, CFP®Eric S. Toya, CFP®