Talking Points for Your Clients on the Recent Market Volatility

We normally (and still) don’t generally react to day-to-day market movements—in fact, as I write this, markets have fallen and reversed on the order of 1.5%.  But, as clients often see negative headlines first and call their advisor second, we wanted to share some items that could be of some help in framing recent volatility into a broader perspective.

 

  • In most years, markets experience at least one corrective -10% decline, and -5% drops can occur as often as once a quarter.  We haven’t seen a drop of -10% in about two years, so we’re about due. That may or may not be much consolation, but it’s the reality.  As we know, markets in any asset are better served by a reasonable few-steps-higher-one-step back type of progression.
  • Since 1950, the average daily volatility of the S&P has hovered around 1% per day (!).  This may be surprising, as it ‘seems’ less volatile in recent years.  Year-to-date in 2014, through yesterday, it’s been at about 0.7%, so slightly below average.
  • More troubled segments such as European equities (recessionary/deflationary conditions) and small-cap stocks (higher valuations), have already entered into ‘correction’ territory.  Large-cap markets have held up well, relative to these segments, which again, does not surprise us, as valuations and fundamentals are stronger.
  • Where is the worry coming from?  Generally, fears about weaker global growth.  This isn’t really news, though. Year-over-year earnings growth estimates, while still positive, have moved downward in recent months from the high single digits down to the mid-single digits for the 3rd Per recent tendencies, it wouldn’t be surprising to see companies beat these estimates.  There are other fears out there as well, including the level of ‘soft landing’ in China, and the Ebola wildcard (the latter due to the lack of information and rampant rumors).

 

Now, the good news:

  • Valuations, our primary metric for evaluation of asset class attractiveness, have moved from near fair value in U.S. large-cap equities, to a bit undervalued with recent price declines.  This situation has historically boded well for forward-looking stock returns.  Foreign equities are even cheaper, albeit with negative sentiment and the headwind of a stronger U.S. dollar as of late.
  • Yields on the bellwether 10-year Treasury Note have fallen to just under 2.0%, the lowest levels since May 2013.  To put this into perspective, based on the last reported year-over-year inflation number (CPI of 1.7%), this puts real yields at under 0.3%.  If the Fed’s 2% inflation target is used instead, that morphs into a zero real yield.  This implies that there is no real economic incentive to own longer-duration bonds.  While traditional ‘safe haven’ bonds have benefitted from this flight to quality, room for upside appears quite limited at this point, and it gets worse the lower yields go (a ‘wound spring’ analogy is an appropriate one here).
  • Seasonally, we’re in a difficult time of year, as we know that Septembers have been typically weak in terms of returns and Octobers have been quite volatile.  However, the strength of 4th quarters as a whole has been persistent through time.
  • Some of the fears are wrapped up around oil prices falling to near $80/barrel.  While certainly not great news for energy companies (and their prices have felt the pinch), this energy cost for many companies and consumers has fallen up to 25% since summer.
  • Company fundamentals are in a much stronger state than they were a few years ago.  This, and the severe depth of the last recession serve as reasons why this recovery has grown in length, and could well continue to persist as cautionary red flags that usually end cycles, such as excessive leverage, high levels of risk-taking sentiment and overbuilding, for a just few examples, have not yet surfaced.
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