template 10/8/2018 1

A look back at October

October brings up all kinds of images: cooler weather, fall colors, the possibility of snow, and of course, Halloween.

For investors, October has a ghoulish reputation. A brief look at the data shows the month that claims Halloween has been unjustly tarnished. The reality, October has historically finished higher. The reality, September is the worst performing month of the year.

However, the same data reveal that October can be a very volatile, and the month that just passed lived up to the historical narrative – volatile and positive. A roller coaster would be an apt description, with heavy selling quickly followed by a sharp upward swing that took the Dow Jones Industrials and the S&P 500 Index to a record close at month’s end.

MTD % / YTD % / 3-year* %
Dow Jones Industrial Average / 2.04 / 4.91 / 13.31
NASDAQ Composite / 3.06 / 10.87 / 19.93
S&P 500 Index / 2.32 / 9.18 / 17.21
Russell 2000 Index / 6.52 / 0.85 / 16.56
MSCI World ex-USA** / -1.66 / -4.46 / 6.05
MSCI Emerging Markets** / 1.07 / 1.33 / 0.68

Source: Wall Street Journal, MSCI.com

*Annualized

**USD

A disciplined approach

When I addressed you at the end of the first quarter, I thoughtfully entitled the commentary, "A Bumpy Road is No Reason to Abandon Stocks." At the time, we were grappling with the economic impact of a frigid winter, Russia’s incursion into Ukraine, and jitters in emerging markets.

The winter morphed into spring and the economic recovery firmed. True, we are still dealing with the situation in Ukraine but so far it’s had little impact on the economic front.

Emerging market stocks blossomed during the summer months and key indexes that measure developing economies reached a three-year high before succumbing to selling pressure that took global markets lower.

Given the selloff in October and subsequent rebound, let me once again emphasize that a bumpy road is no reason to abandon stocks.

Despite the fear and angst created by headlines and a series of triple-digits losses by the Dow, the broader-based S&P 500 Index shed a modest 7.4% from the peak achieved on September 18 and the trough on October 15.

That eclipsed the 5.7% decline in January 2014, but failed to match the 7.7% drop in the fall of 2012. Still, it’s been over three years since the S&P 500 has fallen more than 10%, which would classify it as an official correction.

I’ve always emphasized the importance of stripping emotion out of the investment process and sticking with the investment plan that has been crafted to meet your individual goals. That said, and recognizing that market corrections can be psychologically jarring, I had hoped we might see a more significant drop before eventually returning to new highs – maybe something on the order of 12-15%.

There’s nothing like a cleansing market selloff. It eliminates excess excitement, puts a lid on valuations, and eventually creates a base to fuel new advances.

But the market rarely follows the intended script; hence, the investment approach we recommend is designed to smooth out, not eliminate, the bumps in the road and help you reach your financial destination.

As I’ve often said, a change in your personal situation could prompt a reevaluation of your portfolio, but it’s rarely wise to buy or sell based on emotions. October’s downward blip is a vivid reminder a disciplined approach that strips away the emotional component is the best path to reach your financial goals.

Reasons for the selloff

In recent commentaries, I’ve stressed that I’m watching what’s happening in Europe. The darker economic outlook and anxieties the continent could slip into deflation have prompted the European Central Bank to implement more aggressive monetary measures in June and September.

Historically, a shift in a major central bank’s stance to something more accommodative has been a plus for stocks.

But a European economy that has virtually stalled was suddenly seen as a negative amid worries that weak growth across the Atlantic might slow our recovery and dampen corporate profits. The decision by the International Monetary Fund to reduce its global forecast added to the gloom.

Global economic worries have also pressured commodity prices and oil. Because both stocks and commodities/oil are viewed as relatively riskier assets, sales in one asset class can sometimes spill into another.

Then we have the stronger dollar. Although the evidence discussed last month suggests a bull market in the dollar is more beneficial for stocks over the long-term than a falling dollar, it can create short-term headwinds to revenues for the multinationals.

The uncertainties generated over an eventual rate increase next year by the Federal Reserve have eaten down junk bonds. Problems in the junk bond market can seep into stocks, which was especially true for smaller-company shares.

Just when the news couldn’t get any worse, the Ebola virus reared its ugly head in the U.S. creating anxieties that a pandemic would harm the economy.

It’s been over three years since the last correction. It’s not that valuations are too rich, at least in my view, but the big run-up in shares provided a great excuse to book profits.

Finally, let’s not discount the impact of voluntary and involuntary (margin calls) sales by the major hedge funds.

Fundamentals reassert themselves

As fast as the market fell, a stampede of buy orders completely erased losses, sending key indices to new highs within about two weeks.

For starters, much of the economic data suggest the economy continues to expand at a moderate pace, including preliminary data that indicated Q3 GDP expanded at an annualized pace of 3.5%. Moderate growth is also being reflected in Q3 earnings, which are growing at a respectable pace.

Furthermore, the large industrials, which offer us a “boots-on-the-ground” review of the economy have been providing sanguine forecasts, suggesting fears a global slowdown might wash up on our shores was overblown.

Even if a recession is unavoidable in Europe, U.S. exports to the region last year amounted to 1.5% of the total U.S. economy. “You could talk about a complete catastrophe in exports to Europe, and the hit to growth would be de minimis,” according to Neil Dutta, head of economics at Renaissance Macro Research.

At about 10%, S&P 500 revenue exposure to Europe isn’t that significant either, according to a study by Standard & Poor’s and FactSet Research.

The Ebola virus injected some fear into the markets early in the month, but the virus has not spread, alleviating some of the anxieties that a pandemic would dampen economic growth.

Then we have the influences from the global central banks. Yes, the Federal Reserve is no longer buying long-term bonds. Yes, the first rate hike of the recovery is expected in the middle of next year, but any increases are expected to be gradual, limiting competition with stocks.

Additionally, the Bank of Japan surprised investors on the last day of the month by ramping up its already aggressive series of bond buys, which means that more cash will be spewing into the global financial system. Short-term, that’s a tailwind for stocks.

Things I’m watching—

  1. The Fed has been becoming increasingly vocal about its desire to start raising the fed funds rate at the appropriate time. Rising interest rates can slow a market’s advance as better returns on safe investments create competition for an investor’s savings. But we are coming off an extremely low base.
  1. In the meantime, I’m still watching Europe. Pressure is growing on the European Central Bank to take on an even more aggressive posture The flipside, however, is we could see some volatility and anecdotal examples of firm-specific weakness from those companies that do an inordinate amount of business in Europe.
  1. Oil prices entered into a free-fall last month, briefly stabilized, and have turned lower against the backdrop of reports that Saudi Arabia is cutting prices of oil sold in the U.S. The steep drop in gasoline is keeping extra cash in our pockets, but so far, consumers are doing just that, keeping the cash in their pockets.

You see, the U.S. oil boom has been driven by unconventional shale plays. Costs have been declining but remain high, and estimates as to when production at home could be shuttered vary widely. While consumers stand to benefit, falling prices are casting a long shadow over producers.

That brings us to junk bonds. A study by the Schwab Center for Financial Research revealed that energy companies make up more than 15% of the Barclays U.S. Corporate High-Yield Bond Index, trailing only the communications sector. Falling energy prices reduce cash flow and raise the possibility of delinquencies and default.

While the future is never worry-free, the U.S. economy continues to expand at a moderate pace, which in turn, fuels earnings growth. Any of the factors above, or unforeseen events, can create volatility.

But the investment plans we’ve recommended are well diversified and are designed to reduce unwanted volatility. Let me once again emphasize that it takes the emotional component out of the investment process.

October’s market swoon may have tempted some to sharply pare back on stocks, but then we run the risk of selling low and buying higher. It’s been over three years since the S&P 500 Index has fallen more than 10%. One day, we’ll get that 10% drop. One day, we’ll enter a bear market, defined as a 20% pullback.

It’s impossible to effectively time the market. So let me defer to baseball legend Casey Stengel who once said, “Never make predictions, especially about the future.”

Still, with history as a guide, every decline in stocks has been followed by new highs, and our investment philosophy subscribes to that adage.

I hope you’ve found this review to be both educational and helpful. If you have any questions or would like to discuss any matters, please feel free to give me or any of my team members a call.

As always, I’m honored and humbled that you have given me the opportunity to serve as your financial advisor.