3rd Quarter Client Note

The extreme volatility during the last week of August virtually ordained the market’s performance for the quarter. Stocks were weighed down by China’s slowing economy and the continuing pressure on commodity prices (especially oil.) China has accounted for approximately half the world’s demand for industrial commodities. The Fed continues to waver on raising interest rates; not sure whether to be more influenced by slowing in China or the continued recovery of the US economy.  Full year GDP growth for the US is still expected to be in the 2.2% to 2.6% range and the unemployment rate is down to 5.1%; its lowest level since April 2008.

The S & P 500 (Total Return) Index declined 6.44% (its worst performance since 2011) bringing it down 5.29% year-to-date. Other equity asset classes fared even worse. The Russell 1000 US Value Index dropped 8.39%. The Russell 2000 US Small Cap Index was down 11.92%. Foreign stocks performed the worst. The MSCI Developed Markets Index (net div.) fell 10.57%. While the MSCI Emerging Markets Index (net div.) was down 17.90%.  So clearly, an equity dominant portfolio diversified among these asset classes produced a stomach churning result for the quarter.

Your Life Jacket – High Quality Bonds

In a flight to quality that typically accompanies falling stock prices, the yield on the 10-year Treasury fell from 2.43% to 2.05% resulting in the Barclay’s US Aggregate Bond Index gaining 1.23% for the quarter. Having 30 – 40% of your portfolio in high quality, investment grade bonds worked to keep the damage within reason.

Not so for investors turned off by the low yields in today’s bond markets and who may have ventured into riskier bond categories to capture higher yields. High Yield Bond Funds lost 4.46% and Emerging Markets Bond Funds dropped 6.25% for the quarter.

The Biggest Risk of All: Panic

At the height of the market turmoil I provided some context and perspective in a mid-quarter note entitled Living Near the Fault Line. I encourage you to keep that handy for reference during the inevitable future volatility events. And here’s some further exploration of why it’s so important to have a plan you can stick with during market corrections. At the end of their Quarterly Market Review, the good folks at Dimensional Fund Advisors provide some good solid data to back up this concept in an essay entitled Should Investors Sell After a Correction?

On Monday August 24, the Dow Jones was down over 1,000 points at the open. The S & P 500 declined 12.35% from its record high on May 21 through August 24. These kinds of moves often cause nervous investors to sell — in hopes of avoiding larger losses of 20%, 30% or 40% — and then feeling like they’ll be able to get back in when the smoke clears. Of course, successfully executing such a tactic would require you to be right twice.

As the chart from the original column on which this report is based shows, there have been 262 declines of 5% or more (in US Large Cap stocks) and 28 declines of 10% or more during the period from January 1926 – June 2015.

Obviously, all of the even greater declines started with declines of 10%. And we know there have been just a few of those dramatic top to bottom losses during that period: The Crash of 1929 followed by Great Depression; the Crash of 1987; the popping of Tech Bubble from 2000 – 2003 and the Great Recession of 2007 -2009.

Examining the data, you see that the average length of time for such 10% declines is 4.6 days resulting in an average magnitude of -14.25%. But following those declines, the average annualized compound return has been 23.56% for the next year, 8.89% for three years and 13.33% for five years. Clearly, as I expressed in Living Near the Fault Line, it’s impossible to know for sure while we’re experiencing one of these tremors whether it’s the Big One or just an ordinary correction. But the odds of being right are short.

And being wrong puts your entire, well thought out plan in peril.

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