By Deborah DeMatteo
Managing Director & Chief Investment Officer
Can one month rewrite the last chapter of 2015? When we started the year, all expectations were for the market to continue its path on posting another gain, the Federal Reserve would begin raising interest rates, and the economy would continue to strengthen with an improving labor and housing market. The average forecast for 2015 of the top 15 Wall Street strategists was for a roughly 7.5 percent gain in the S&P 500, fairly modest, but still a decent showing. In January Ed Keon, portfolio manager at Quantitative Management Associates, summed it up by stating “I think it’s going to be another good year for the market, and a very good year for the U.S. economy. This might be the first year the improvement in the economy is felt by a broader group of people.” So when we closed the books on August with the markets turning in one of the worst months in decades, the Dow and S&P 500 now in negative territory for the year, where do we go from here?
Let’s first take a look at what happened during the past month, The Dow Jones and the S&P 500 were each down over 6 percent. This would mark the sixth worst monthly performance for the Dow Jones Industrial Average. In addition to the overall declines in the equities we needed to digest the unprecedented volatility in the oil markets. Believe it or not, oil was up for the month but it was a wild ride that added confusion to the market. Although we finished the month slightly over $47 per barrel, up 4.4 percent, WTI traded as high as $58.98 and as low as $37.75 per barrel. In comparison to stocks and oil, the Treasury market seemed calm. Rates were little changed on the month but swung slightly more than 13 percent during the month, from a low of just over 2 percent to a high of 2.27 percent. We can only call that relatively calm, normally a 13 percent swing during the month from the highs to the lows is not what we expect from the treasury market.
In his outlook for the market in January, Ed Keon did warn that the markets biggest risk is its own complacency. “After so many good years in a row, anything we get as an outside shock could have a big impact on our market. Stocks are more vulnerable to volatility.” This is something we have talked about and expected this year. Volatility is measured by an index known as the VIX. For most of the mid 2000’s volatility had been unusually low. By 2006-2007 volatility fell to some of the lowest levels we had seen since all periods going back to the 1950’s. Then in 2008 volatility surged to starting and anxiety producing levels. Again in 2013 -2014 an eerie calm had come over the markets once again. It remained that way until August when the VIX surged from 12.12 to above 40, an increase over 236 percent for the month. To put this in perspective, over the last 20 years prior to this recent move, the VIX has traded above 35 only 7 times. Notable events occurred in tandem with those moves including the first day of trading after the World Trade Center attacks, the collapse of Lehman Brothers in 2008, and the Debt Crisis in Europe in 2011. Although the S&P 500 established a new low after each spike, 6 months after each of the 7 spikes the S&P 500 was up an average of 20 percent.
Volatility plays an important role in the markets and just as importantly how investors react to the market. In a recent paper titled How Market Volatility Affects Our Brains, Author Wesley R. Gray Ph.D., addresses how stress affects decision making. Through his research he came to the conclusion that humans don’t have stable risk preferences, stress makes us more risk– averse. He points out that market volatility causes stress and in turn makes us more risk averse. He studied investors’ reaction to dropping stock prices. The economic assumption is that if prices drop by 20 percent, there is more potential return, and therefore investors should see value and be more inclined to buy. However what he found is that the steeper the decline the less likely an investor was to be compelled to take on risk. An even greater contributor to stress is volatility.
This may help explain why with the wild swings in market, investors sold everything including stocks, bonds, commodities, and international funds. July and August was the first two month stretch that retail investors had pulled money from both stock and bond funds since the end of 2008, according to Credit Suisse. Not only did the VIX spike as we noted earlier, but the market experienced several record reversals during the month. For the blue chip sector the Dow Jones was down 6.62 percent, at its lows for the week ending 8/28, and ended up positive at 1.11 percent; in its biggest reversal since the last week of October 1987. The Nasdaq Composite ended up 2.6 percent, for the same week, recovering more than an 8.79 percent plunge, the biggest intra-week reversal on record. Although we don’t know the depth of the current decline, or the timing of the rebound that will likely follow, if history is any lesson, this is not likely the time to be selling.
What we need to keep focus of is the economy and long term investing fundamentals. The economy is continuing to show signs of strength. Two key industries, housing and automobiles, remain on track to post very good numbers. We are on track for over 500K single family home sold this year, surpassing the average of 385K per year since 2008. Still that is well off the peak of 1.3 million units sold in 2005, but we are continuing to head in the right direction. We can see the same thing in Auto Industry. Current sales indicate that we will sell over 17 million cars this year. At the bottom in 2009 we sold less than 10 million. Both of these industries create jobs and additional spending by consumers. Although first quarter GDP came in at just .6 percent, a traditionally weak quarter, second quarter GDP was 3.7 percent. We don’t know yet what the third quarter is going to look like and if the recent market volatility will have any impact. The risks to the U.S. economy from around the world are real, but currently we continue to see signs of improvement. Hopefully a tailwind of lower gas prices will encourage consumers to do a little spending.
While we await a decision from the Federal Reserve later this month, we expect the volatility to continue. China remains a very large question that will not be answered any time soon. While we certainly don’t know for sure what the direction of the market is in the very near term, we are confident in our long term strategy. If you are feeling stressed by what you see happening, as you now know it is normal, and you are not alone. Remember we are working every day to filter out the noise and not allow the emotions of what drives the daily swings to affect our investment strategy. Chaos likely presents opportunity for those who are patient.