The Return of Volatility

October 17, 2014

Fall arrived right on schedule. As if choreographed from above, the clouds and rain appeared just as the calendar turned, a wonderfully synchronized chronology for our seasonal switch. In similar fashion, our capital markets heralded the changing of the seasons with their own bout of unsettled weather. While falling far short of stormy conditions, we nonetheless have endured some cloudy cooler days along with the occasional cold shower in the capital markets, reminding us that every day can’t be sunny after all.

Last quarter, we talked about the ‘efficient frontier’ and the beneficial effect over time of combining asset classes within your portfolio that don’t move in lock-step with each other. Looking at the world’s stock markets over this last quarter has given us a ready example of different markets moving differently. While large US stocks finished the quarter in positive territory, international equities had a tougher go of it, buffeted by concerns about Ukraine, Africa and slowing economic growth in both Asia and Europe.

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Domestic stocks seemed to take their cue from valuations, both over the quarter and year to date. The smallest companies have long been trading at valuations considerably richer than the market as a whole and that market segment ran counter to the trend of their larger brethren. Prices in small company stocks have struggled this year so far and were finally pushed into negative territory with September’s weakness. Valuations pay a pivotal role in the context of future performance and we spend significant time analyzing these valuations and using that information to tailor the weightings in your portfolio. Not surprisingly, we have been significantly underweight in smaller US stocks and have emphasized larger domestic stocks in your portfolio.

While those smaller companies here in the US may still be trading at values that are a bit higher than normal, the bulk of the US market is priced at a level very close to average. Price to earnings ratios (the multiple of yearly earnings that a stock trades at) have modestly crept up year over year, but forward looking ratios (using estimated earnings for the year ahead) look very reasonable. Estimating next year’s earnings and using those as the beginning of one’s calculation of fair value introduces a fair amount of uncertainty. While the future is simply unknowable, we can nonetheless be guided to some extent by the trends in place today and right now those trends continue to indicate a slowly growing economy here in the US with progress being made on the employment front, reasons to think that those forward looking estimates of earnings may not be too far off over all.

To read the full third quarter client article go to www.LSAportfolios.com login and go to Resources/Articles.  If you are not an LSA member e-mail us at support@LSAportfolios.com and we will get a copy of the article to you.